RAY DALIO: “To be successful as an investor, you have to bet against the consensus and be right”
This means when it comes to successful investing it pays to be a contrarian.
At first this might seem counter intuitive but what we are really talking about here is the predictable patterns found in mass psychology that are reliable and constant in a world of constant change and flux.
Let me use a picture to illustrate this point:
Notice how the mass heard psychology wants to do the exact opposite of what the successful investor would do?
Everyone wants to buy Bitcoin at $20,000 but nobody wanted it at $200 – this theme is consistent across all asset classes.
The right time to enter and the right time to exit are the opposite of what the heard mentality thinks it is.
This doesn’t make your job as an investor any easier because you still need to accurately gauge where the cycle is and it also means the heard will be making fun of you when you are not part of the consensus.
Social pressure is very hard to go against.
Whether you are trading financial markets, in the property game, building a business or investing in crypto currency the money is made doing the OPPOSITE of what the herd mentality is.
However, what happens when you bet against the herd and your wrong?
You get trampled by the herd.
So timing is everything but timing its tricky.
Should you get the timing wrong (which is likely to happen more often than not) a risk measure which prevents you from getting trampled is vital.
Good Money Management is the art of enforcing this very risk measure.
Learning Money Management
NOTE: This critical topic is frequently overlooked because it wont sell books or clicks however it is PARAMOUNT that you master it if you are to become a successful trader or investor.
In the case of trading new traders are in a hurry to make money, the last thing they want to to do or be told is to slow down or to implement a risk measure that will allow them to survive before they can thrive if it comes at the cost of their perceived ‘fast money’ opportunity.
So what ends up happening is that they it smile and nod or agree to the advice and then proceed NOT to follow or implement it.
Hey you can lead a horse to water but you cant make it drink.
Since so many got burned in crypto BOOM and BUST of 2018 the advice is starting to stick with the smarter ones.
So what exactly is Money Management?
Money Management refers to the management of one’s entire investment portfolio.
Chris Dunn would do this by breaking his portfolio up into what he would call his different ‘capital buckets’ and then he would measure these buckets against his personal net worth as percentages in order to make money management decisions.
Hypothetically if an investment ballooned from 10% to 50% of his paper net worth this would be a very very strong cue for him to take ‘hard’ profit (permanent realized profit).
Once this is done he would reallocate his investment portfolio so that no single point of potential failure is over his 10% rule.
Now that Chris is wealthier from his hard profit taking, this 10% figure may be substantially higher than what it used to be in real money terms but it has been readjusted to ensure it still only represents 10% of his new net worth for risk (money management) purposes.
Because he had the wisdom to take hard profit his real (not paper) net worth is now much higher.
Consistently applying this technique overtime will ensure that you can compound profits while managing your risk to limit your downside risks.
Everyone is different and 10% may be too big or too small depending on your strategy and the current market conditions but what matters is the principle behind the actions he took and the fact that he has a plan.
This is an excellent way of implementing good Money Management.
So how would one implement good money management like Chris Dunn?
Firstly, Label and Quarantine Your ‘Non-Risk Capital‘ Bucket
Non-risk capital is money you use for paying the bills, covering living costs and running your daily life. This is money you would never risk in any capacity because it sustains your living, this would include mortgage payments, gas, electricity, food etcetera.
Ideally you wouldn’t be servicing any debt for depreciating assets that make your non-risk capital expenses balloon i.e. car loans, holiday loans, wedding loans, credit card debt but if you do you would ensure this is covered while trying to eliminate it as soon as possible before you start building a ‘Risk Capital’ bucket.
Quiet simply Non-Risk Capital is never risked or used for investment. You need to understand what portion of your income needs to be reserved to cover this and then anything above and beyond this can be allocated to a seperate ‘Risk Capital’ bucket.
If you are in a situation where you have little or no spare capital above your Non-risk Capital expenses you need to work on changing your circumstances so that you do.
Essentially you need to cut expenses and increase your income. Read this to learn how to increase your income.
Second, Label and Split Up Your ‘Risk Capital‘ Bucket Into Separate Smaller Buckets
Once your Non-risk Capital is separate and allocated you can freely utilize what’s left in a safe manner. What’s left is your Risk Capital.
As part of implementing good money management you should split up your risk capital into different buckets.
Everyone will be at different stages of their own investment and wealth building journey however, irrespective of if you have $10,000 or $10,000,000 these capital buckets and risk management methods should be universally understood and applied as they are applicable to any portfolio size.
If you are at the beginning of your journey it is especially important to learn good money management NOW while your risk capital bucket is small so that you have experience should you successfully grow it to become a big risk capital bucket.
As UGLY OLD GOAT says “many big traders become small traders, most small traders stay small traders, a few small traders become big traders. . . and the wise big traders choose to become small traders again.“
Ponder that wisdom and reflect on it as you continue to learn good money management.
Okay so here is how we split up our Risk Capital buckets:
Bucket A) Long Term Investment Capital
This is part of your risk capital that you dedicate to long term investments or ‘accumulation plays’.
The best time to make these kinds of investments is during Phase 1 or early Phase 2 of the 5 Major Market Cycle Phases. During these phases you essentially ‘just buy’ and are not particularly concerned about nailing exact price.
You might think about how much of a particular asset you want to own and think about your position in terms of it’s overall general average price.
You don’t spend time thinking about or obsessing about the price since you are making a long term play and you are relatively confident you are buying at the low or near the bottom of the market cycle (i.e. Phase 1 – accumulation where there is low volatility and its ‘boring’).
A key part of this strategy is the concept of ‘averaging down’ and thinking about your average price over time for example:
If you accumulated Bitcoin in early 2019 you might have bought some at $4200 US, $3200 US and $3600 US. Assuming you bought the same amount each time your average fill price is $3666.66 US Dollars.
Now that its gone up above $10,000 US Dollars in August 2019 the price range differences between your buy fills seem like nothing! See how this works?
It’s very unlikely you will nail the bottom however you are not concerned since you are looking to make your money over the longer term greater market cycle which could be multi-decade, multi-year or multi-month depending on the asset you are buying.
To give you an idea a real estate play may take years or decades to play out while a crypto-currency play may take only months.
During any ‘accumulation play’ you are likely to have a draw-down which you need to be comfortable with.
To follow this strategy from beginning (Phase 1 – accumulation) to end (Phase 3 – harvesting during the parabolic run) this may be considered a ‘position trade’ which would play out over 2 to 3 years or one full Bitcoin market cycle in the instance of crypto currency.
Since the cryptocurrency market is still maturing each market cycle is likely to get longer in time-scale.
These kinds of long term investments or accumulation plays are very passive since you are not actively buying or selling but they are often where the largest amounts of money are made.
Bucket B) Short Term Investments or Trading Capital
This is capital that you actively deploy during the intermediate runs and retracements of a market. This means you might see a buying opportunity or break out trade as part of your Technical Analysis and you are looking to make short term gains with this part of your capital.
As an example in crypto-currency or stock trading as an active trader you might be attempting a Bounce Play, Breakout Play, Swing Trade or be speculating over a Fundamental Event (air-drop, miner reward block halving etcetera) and you would expect this to happen over the course of a day, few days to a few months.
In this kind of play you want to get in and get out quickly as part of your risk management strategy.
BONUS Bucket C) Venture Investing (Angel or Startup)
This kind of investment is a long term investment made while acknowledging the extreme levels of risk involved.
Usually you wouldn’t be engaged in venture investing until you have made life changing money through your other investment strategies first (i.e. A successful accumulation play of Bitcoin with a sale in the Parabola).
For venture investors there is a high probability that you could lose the whole position but if the project doesn’t fail and rather succeeds; you stand to make huge amounts of money over the long term.
Most startups fail however for the ones that don’t go on to create or take market share in a new business or industry which means the returns can be immense.
An example of a successful venture investment would be an early investment in something like Facebook or Amazon. If these investments work out and are held over the long term (5+ years) investors have been known to facilitate decamillion, hectomillion or billion dollar exits when they cash in.
An example of a successful Venture Capital investment in Cryptocurrency was when VC Tim Draper bought the Silk Road bitcoin (bitcoin sized by the US government and auctioned off) during the 2015 Accumulation Rage before the crypto boom of 2017. While others thought ‘bitcoin was finished’ Tim played the contrarian game and bought almost 30,000 coins at an approximate price of $600 USD per coin.
Imagine having that position when it went to 20,000 US Dollars at the peak in 2017! You know what they say – fortune favors the bold.
By the way Tim didnt sell all of his bitcoin and still has a long term price target of $250,000 US Dollars per Bitcoin.
How to implement Money Management into your Capital Buckets:
Now that your capital is split into buckets for dedicated purposes it’s time to protect these buckets using money management techniques.
This means putting rules and measures in place like:
Not putting all of your eggs in 1 basket i.e. not going all in on a speculative play with a whole capital bucket.
Position sizing – taking trades or positions with 5% or 10% of your capital bucket in case you are wrong about the direction of the market i.e. if you lose it all you still have 90% in reserve.
Dollar cost averaging – buying amounts in sections to get a better average price fill through the ups and downs of an ‘accumulation range’.
Taking hard profit when a winning position now represents a much larger percentage of your investments i.e. re-calibrating to realize profit and then lower risk.
Measuring and monitoring success by analyzing the value of your overall portfolio (separate from your non-risk capital) and the percentages each investment represents.
The extent to which you follow these actions and assign percentages to them is subjective as different people have different convictions about which investments should receive more capital allocation.
However, as a general guide this might mean never putting more that 10% or 20% of a capital bucket into any one kind of investment at one time.
Money Management is the act of protecting your capital so that you can stay in the investment game long enough to succeed.
Money Management allows you to manage your capital so that you can weather the storms without having a large weakness or single point of failure.
Use ‘Capital Buckets’ so your expense money is safe and your risk capital is split up appropriately to manage your risk.
If an investment position grows rapidly and suddenly represents a much larger percentage of your overall portfolio i.e. 10% of your holdings rapidly grow to represent 50% of your investment net worth; SELL IT and take hard profit.
Have a plan and a strategy and stick to it.
Understand the 5 Market Cycle Phases before investing in anything.
I’ll see you in the trenches!