The Reality about Financial Freedom and Trading23rd May 2019
Financial Freedom is “a term generally used to describe the state of having sufficient personal wealth to live indefinitely without having to work actively for basic necessities” – Wikipedia
Our recent feedback from the Content Questionnaire (which is a permanent feedback page you can find here), has already highlighted a key topic that needs further investigation: Financial Freedom and Trading.
Here are the facts:
- there is too much hype around “trading as a means to reach financial freedom”. We will discuss what reality is.
- there is too little focus on actual number crunching and what your “critical mass” needs to be, in order to be financially free.
- there is no focus on the correct process to reach financial freedom.
This blog post will illustrate some points that you will not likely want to hear, but that you need to know.
Step 1: How to Build Wealth
This is the reality that most people do not want to hear. It takes discipline and sacrifice to reach financial freedom. There are no shortcuts. The process goes as follows:
- Cut Spending
- Owe Nothing
Cut Spending: we need to take a hard look at our day to day expenses if we want to get on the road to financial freedom. We can be as philosophical as you want but the fact is that you must keep track of your spending. How are you spending your money? Where is it going? Detach your ego from your money. It’s not about keeping up with the Jones. Furthermore, it is scientifically proven that the relationship between income and happiness is weak. So spending more does not make you happier.
Owe Nothing: as you cut your spending, you will free up capital that can help repay your debt. All credit cards, car finance, student loans, etc. needs to be eliminated. Debt is compound interest working against you. You need to turn this around and have compound interest work FOR you.
Save!: once you are debt-free and you are living in a rather frugal manner, you should be able to save a fair share of your income. Back in the day, I was told to live on 30% of my income and save 70%. That seems to be challenging nowadays so start wherever you can but try to aim for 50% of your income. Of course a higher paying job allows you to save more. Those with lower wages may be able to save less. If you cannot save at all, do whatever is necessary to make extra income (and I would not suggest trading as a way to produce a side income at all – instead, work to your strengths and use talents and abilities you already possess).
Invest: If debt is compound interest working against you, investing is compound interest wokring FOR you. Just think that at 12% per year, your money doubles every 6 years. This may not seem much if you are turning $5000 into $10000 but just let that math work for you for few more years and things start to look interesting. Investing in a smart way (for example in a long-term diversified portfolio of Value Stocks or by using Ray Dalio’s All-Weather approach) can help you achieve consistent growth of your savings portfolio with limited risk. The key here is to be diversified because diversification is what helps to protect your savings. If you have even more capital at your disposal, consider diversifying into business ventures, property or other fruitful ventures. The wealthy remain wealthy because they are well diversified in the financial and real economy.
Notice that trading has not yet been mentioned. Trading has it’s place, but not at this stage in the journey.
Step 2: Calculating Your Critical Mass
Personal finance gurus, as well as motivational speakers like Tony Robbins, speak about a “critical mass” that your investments need to reach, in order for you to be financially free. But in numbers, what does that mean?
I have come to appreciate the Trinity Study. Essentially researchers sought to understand what kind of Safe Withdrawal Rate was possible, given a certain return on investment, so you would never run out of capital. The Safe Withdrawal Rate logic goes as follows: you want to be financially independent and not work anymore. In academic vernacular, that’s called “retirement”. I disagree with the fact that we should aim at “retiring” because humans tend to face depression and other mental issues when they are not engaged in meaningful work.
In any case, when you are retired, you need to live off your savings. Hence, you will be withdrawing a certain amount each month. The Trinity Study attempts to answer the question: how much can you withdraw each year, in order to remain above your critical mass and continue to grow your investments?
Recently, one of the leading retirement researchers, Wade Pfau, updated the numbers and modeled the Safe Withdrawal Rate for a conservative 50% stock – 50% bond portfolio for a retirement starting in each year going all the way back to 1926 (through 2010). You can see that the maximum SWR to avoid failure did not go below 4% over any 30-year time period.
There are all sorts of caveats, but the reasoning is sound: if you stick to 4% of your savings, then your investments should be able to compensate more than adequately. This means that your critical mass is about 25x your current annual expenses. This spreadsheet will help put things into perspective:
Souce: Author’s Calculations
So based on these calculations, with an average real ROI of 5% (a conservative estimate), a 35 year-old with this situation could reach financial independence by the age of 60. Obviously, the sooner you start saving and investing, the faster this growth can happen.
- higher savings rates will shorten the time to independence (so if you get promoted, or you get extra income streams, be sure to tuck that extra away and not enhance your spending alongside your salary!);
- higher investment returns will shorten the time to independence;
- lower expenses (living frugal) will shorten the time to independence;
if you continue to work after you reach the critical mass, you can afford to have higher spending rates and/or lower ROI.
Step 3: Bring Your Trading to the Table
Now we can bring Trading back into the picture. Tradingis an attempt at enhancing your compound interest by achieving superior ROI. You are essentially trying to compress time. However, too many people have not yet appreciated the truth about trading:
Most likely, trading will not make you rich. Actually, you may end out worse off if you are not careful.
The belief that trading is the way to financial freedom is false – period. Let me dismantle this lie piece by piece.
Firstly, trading is an entrepreneurial job like many others. A fair amount of traders that have come to me for help over the years bought into the idea that trading was some kind of part-time endeavour to be done by the pool or possibly from Hawaii, 30 minutes a day. These people take up trading thinking that it will be an easy way to make money without having a boss, without having certain time constraints, and without having the stress that a 9 to 5 job brings with it.
Now hear this: the very people that bring these beliefs to the table usually lack the entrepreneurial mindset that trading requires. As an employee, you can have bad days that may go unnoticed. As a trader, a bad day can potentially mean losing your prior month’s gains in a heartbeat. As an employee, not being focused or concentrated at times may go unnoticed. As a trader, a lack of focus means facing incremental losses. As an employee, you know that at the end of the month you will receive a paycheck anyhow, unless you do something dire. As a trader, there is no guarantee you will ever get paid.
It takes a fierce commitment, total accountability and sheer grit to get profitable in the markets. It is very similar to creating a start-up and reaching the breakeven point. Not many people are cut out to face this kind of challenge.
Secondly, you need money in order to risk money. Trading is about taking risks with your hard earned money. If you do not have any money to risk, you cannot trade – end of story. If you need money or have any kind of financial constraint, you cannot trade – end of story. This is why trading and investing are usually pursued by High Net Worth Individuals (HNWI) or at least wealthy people that are already business owners or have had a decent career elsewhere. They already have a large chunk of savings behind them and can afford to risk money in the markets without worrying about paying the bills. Furthermore, the fact that they have reached such a lifestyle already says something about their mindset: they are usually hard-working individuals that are accustomed to rolling up their sleeves in order to obtain something or reach a goal.
Not so with most retail traders and aspiring traders I have met. They are not used to working hard. They are not used to taking responsibility for their results. They are not willing to play the long game. They are looking for short-cuts. To make matters worse, they usually don’t have any risk capital at all. Typical retail trader accounts go anywhere from $500 to $2000.
Now hear this: to make a living from trading in a sustainable fashion, you will need a mid 6-figure amount of risk capital. The math is simple:
Let’s imagine for a moment that you need $40.000 to live the lifestyle you want. That $40.000 should be a return of anywhere from 15 to 20% (per year) of your risk capital. Traders that know what they are doing can get 20% consistently with acceptable volatility. If your return is $40.000 and that is 20% of your risk capital, then you should have at least $200.000 to risk in the markets. I have only met a handful of aspiring traders that actually met that criteria.
Your risk capital should be between 5% and 10% of your total net worth. Any more and a depletion of your trading account for whatever reason, could put a big dent in your lifestyle. Using the numbers above, that means your total portfolio should be worth at least $2.000.000. Notice that this is much higher than the critical mass required to sustain the same living costs.
This brings us to the third consideration: most professional traders do not trade their own capital. It just doesn’t make sense. They usually find ways to leverage their talent and solicit investor capital. They trade other people’s money for a fee. Not all professional traders decide to setup funds. Some do in fact trade their own capital but they remain well diversified: they might have a stake in another business or have their own business in another sector; they might have a portfolio of investments that include real estate and other income-bearing assets. The bottom line is that amongst professionals, hardly anyone goes off to trade their own capital.
Now hear this: if the professionals in this field believe it is better to not risk all their savings in the markets, but that it is better to work with other people’s money instead, why should retail traders do the opposite? Perhaps because aspiring traders have not yet experienced the inconsistent returns that trading can (and does) bring with it. It is extremely difficult to rake in consistent profits month after month.
The math goes as follows: the first year you make 20% or $40.000. To some, that may sound like a great accomplishment. But if you’re living in a G10 economy, it’s probably not going to buy you that great lifestyle you want. Let’s say you conservatively withdraw $30.000 for living expenses. Your trading account is at $210.000. Now what if the second year you don’t make 20%. What if you make 10%? Can you break even with your living expenses if you make $21.000? I don’t know many people (in G10 economies) that can. If you need to withdraw $30.000 again, you’re eating up all your remaining profits from year 1 and year 2 and you’re left with less than your initial $200.000 balance. Now what if the third year actually produces a loss? What then?
You can immediately see that if you mix your risk capital with your critical mass, it becomes a very risky proposition because a bad year in the markets can seriously derail your whole process of living frugal, saving up, investing and being patient.
Trading As a Satellite Activity
Just like investment professionals have a “core” and “satellite” portfolio, I suggest you use Step 1 and 2 described above as your “core” activity, and trading as a “satellite” activity. I do not advocate trading your own capital, unless of course you are already in a very good financial position. I also suggest seeking help from professionals or former traders, in order to shorten your learning curve and avoid unnecessary stress.
By all means pursue your dream of trading for a living, but do so wisely: learn how to trade on a demo account. Then, with a solid method in hand, deploy a small amount of your risk capital and grow it slowly but steadily.
Then, seek investors. There will always be an opportunity waiting, for those who know how to trade. That is the pathway I suggest you pursue.
- Give yourself time to learn on a demo.
- Once consistent, trade on a small live account.
- Grow your account steadily over time.
- Increase your resourcefulness during this time.
- Come back to FXRenew with your track record and allow us to take you to bigger & better things.
With this pathway, you can develop your trading into a fruitful business and actually reduce the amount of years it will take to reach your critical mass, and allow you to live a more relaxed life in any case.
Over to You
Financial freedom is all about discipline and humility. It’s about tracking your expenses and keeping them under control; it’s about saving as much as possible; it’s about investing in a simple yet smart way; it’s about starting early (or if you still haven’t, start NOW) and using the power of compounding to assist you.
Trading can have it’s place as a satellite activity alongside the core principles of financial freedom. Trading can allow for 20+% returns per year and if you are trading a sizeable amount, it will not take long to reach your critical mass, and get to a bigger & better place. Here’s an example with some reasonably conservative numbers:
- you commit to learning a disciplined rule-based trading model and give yourself 1 year to fully understand and demo trade it until you reach consistency.
- you then trade a small account (5-10K) of your own capital maintaining a very good control of risk limits. If you can make 3% per month without risking more than 3% it is excellent.
- in year 3, you bring your account statement to FXRenew for evaluation.
- At the beginning of year 4, you start working on investor capital. Let’s conservatively say $100.000. You end year 4 with 20% and receive an even larger allocation for year 5. You made 20K on the account and conservatively keep $5000.
- In year 5 you make 20% on 300.000. That is 60K of which you conservatively keep $15.000.
- In year 7 you make it to 1Mln Assets Under Management. You make 15%. That is 150K of which you conservatively keep $40.000.
All the while you have maintained your other investments and perhaps even your previous employment and are now in a position to consider substituting your employment with your trading income.
Hopefully, armed with reality, you will now be in a better place to take responsibility for your financial destiny.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals and Education from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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