The first step in understanding and building a solid money management plan, the key component in successful trading strategies, is setting realistic profit expectations. All too often I see people open trading accounts with balances of $10,000 or under expecting to make enough money to support themselves from their trading profits within a short period of time. After seeing all of the hype that is out there surrounding most trading education, trading signal services, etc it is no wonder that people think this is a reasonable goal, but that does not make it a realistic one.
As most any truly successful trader will tell you, the stock market has averaged somewhere in the neighborhood of 10% a year over the last 100 years. What this basically means is that if you would have invested in the 30 stocks that make up the Dow Jones Industrial Average, the index which is designed to represent the overall market, you would have earned about 10% on your money on average over the last 100 years. With this in mind, what most any truly successful trader will also tell you, is that if you can consistently double that return, on average, over the long term, then you will be considered among the best traders out there.
So does this mean that if you are a new trader starting with a small account balance that you have no chance of earning a living or even becoming rich from trading? No it does not. But what it does mean is that in order to be successful your expectations need to be in line with reality, so you can develop a stock, futures or forex trading strategy that will allow you to succeed over the long term, instead of following the path of most small traders who swing for the fences on every trade until they eventually blow their entire account up.
With this in mind lets look at a couple of scenarios. What most successful traders will also tell you, is that as a small trader you have much more flexibility regarding what you can put money into as your small trade size is an advantage in the sense that you do not move the market or catch the attention of other traders who may try to profit off what you are doing at your expense. With this in mind I think that most successful traders will tell you that it is not unreasonable to target 30% a year while you are small. Now, assuming you left your profits in your trading account at the end of each year so that you could compound your returns and averaged 30% each year (with obviously some years being worse than this and some years being better) your returns and account balance would look something like the following assuming you started with $10,000.
Now depending on where you live and what your financial requirements to live are, you may be satisfied with this. If you are not however does this mean that you are doomed to never live your dream of being a professional trader? No it does not. If you can produce those types of returns consistently what most successful traders will also tell you is that there will be people lined up at your door to offer you money to trade, and after the 3rd year or so with a successful track record, you should be able to raise enough money to make a very good living trading other people’s money.
Most successful money managers charge management and performance fees somewhere in the neighborhood of 2 and 20 (that is 2% of assets under management yearly and 20% of net new profits) as their compensation for managing other people’s money. With this in mind if you were able to produce a track record similar to the one above for two to three years running and then raised $5 Million (what should be an easy feat with that track record) then your yearly management fee would amount to $100,000. On top of this if you were able to return 30% on that $5 Million then your performance fee would be $300,000 earning you a total compensation of $400,000.
With this in mind, contrary to popular belief which is if you have a small account the only way to be successful is to swing for the fences at first and then scale back when you are large, a much higher probability and most likely faster way to success is to focus on building a consistently profitable trading strategy and then taking on capital from others in order to earn your living trading.
That completes our lesson for today. In tomorrows lesson we are going to look at different ways of protecting one’s capital while trading so we hope to see you in that lesson.
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