In this article, I continue with my three-part series of articles on Investment 101: Tenets of successful investing. If perhaps, you haven’t read the First part of this series, you can check it out here before proceeding to read this Second part.
I stated in my first article, that our job as professional investors is to do a superior job, and our superiority comes from producing good returns earned with the risks under control. I am repeating this statement because I want to maintain it as the central theme that runs through this series of articles.
In this article, I discuss three additional principles that should serve as foundational principles and benchmarks required to generate good returns from investment, earned with the risks under control.
We would look at the Capital Principle, the Leverage/Gearing Principle and the Pitch Principle in this second part.
- THE CAPITAL PRINCIPLE;
The capital principle entreats investors to invest with money they can afford to lose – especially when it has to do with high yielding investment ventures where the risk of loss are extremely high. Because asset prices are predominantly influenced by economic and political happenings which are most of the time unpredictable, there is some degree of uncertainty associated with market price movements.
In view of this, it is always essential that one invests with money/resources that will not put them in any financial mishap when lost. Investing with money you can afford to lose generally gives you security and peace of mind so you don’t have to interfere with your investment before the maturity period.
Also, ensure that to the best of your knowledge and all else being equal, you will not need the said capital for any other use during the life of the investment. This enables you to hold the investment up to the stated maturity period so as to be able to earn all the associated returns. Many money managers and investment firms will actually charge you commissions and in some cases deny you part or all of the accrued returns if you are to liquidate your investment before the stated maturity date. Investing with money you can afford to lose and do not need for immediate use gives you enough room to accommodate all the inherent risk and also hold the investment up to the stated maturity date.
- THE LEVERAGE/GEARING PRINCIPLE;
The principle of leverage simply states: get high leverage! The leverage principle encourages investors to make use of borrowed funds or debt to magnify investment returns. It is the act of investing with third party funds and/or investing in leveraged assets. Despite the merits of financial leverage, readers must note that, this is an advance principle, used by highly experienced investment professionals to scale up their marginal investment returns.
The principle of financial leverage is mostly used in big ticket investment transactions with long term returns such as; sovereign debt, real estate and in commodities such as oil, Gold and Silver where huge investment funds are required.
Sometimes you may come across a potentially lucrative investment opportunity but may not have all the funds needed to take advantage of the investment opportunity. In such instances, gearing is the key. One may have access to leveraged funds through prop firms, supportive friends and relatives, network of investors, collective savings and investment groups or simply through fund raising. The objective is to raise long term funds that have very relaxed terms and conditions and at a little or no interest, so the investor can have the ease of time and space to go about their investment with peace of mind.
On the whole, to be able to raise funds much more successfully, requires that one has integrity and a good track record of successful investing.
The key to applying leverage successfully is to be able to keep the downside risk under control, in that, if you can manage and contain the downside of possible loss effectively, you can control leverage risk. This can be done by brainstorming the worst case scenarios that can arise and then appropriately aligning effective risk mitigation measures that will curtail those probable downside risks. Failure to do this may signal that the risk you are going in for is probably bigger than you can handle.
The other aspect of financial Leverage is in the use of various financial instruments that requires the use of margin such as CFDs (Contract for Difference). The use of margin requirement allows an investor to invest in a financial security by putting down only a certain percentage amount of the actual value of the security with cash. Thus, it allows investors to invest in a security without having to pay for its entire value with cash.
Margin requirement is the percentage amount that an investor must pay with their own cash when investing in marginable securities whiles maintenance margin is the minimum amount of equity/cash that must be maintained in a margin account in order to hold an investment position.
In practical terms, the maintenance margin serves as a collateral for the use of leverage in a margin account and your investment broker would give you a margin call, requesting you to add up additional funds, should your account equity fall below the maintenance margin at the same time that you have an open investment position in your margin account.
Investing in leverage securities can be done by investing with brokers that offer margin accounts for investment purposes. Some brokers offer as high as between 25% to 50% maintenance margin.
A 50% maintenance margin implies that, you are only required to maintain 50% of the actual value of the security in your account to have an open position on the margin account. For example, if you were to go long on Gold in a margin account at a price of $1000 per ounce, a 50% maintenance margin implies that you are required to maintain a minimum of 50% [$500] of the actual value of this investment in your margin account in order to maintain your open long position on gold. If your account equity is to fall below this value, your broker would request that you put in additional funds by given you a margin call.
Notwithstanding the benefits of financial leverage in magnifying returns on investment, investors must be aware that using leverage can only be rewarding when the going is good, but it can also wipe you out if events do not conform to expectations.
- THE PITCH PRINCIPLE;
The pitch principle in investing essentially has to do with knowing what to do and when to do it – which is very crucial in determining long term investing success or failure. Essentially, the pitch principle entreats investors to know how to lie in wait for the “perfect” time to make an investment move.
Given that market cycles are binal; primarily bull and bear cycles, an astute investor should be able to properly tell the general directional bias of markets from time to time and be able to unemotionally react accordingly.
Generally, there are basically three options available to every investor in the moment of decision; you are either short, long or you stand aside. Which is pretty simple, but very hard to do. Shorting in bull markets will make an investor go bankrupt just as going long in bear markets.
Author: E.O Essien
E.O. Essien is a Chartered Economist with accreditation from the Global Academy of Finance and Management (GAFM) and the Association of Certified Chartered Economist (ACCE). He is a professional currency speculator, economic columnist and an Investment Analyst. You may reach him via email on firstname.lastname@example.org or on 0203656160, he will be glad to hear from you.