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Compound interest and other strategies

October 19, 2020
11 min
Compound interest and other strategies
Beginner
You will learn

    HOW and WHEN?

    In order to determine which investment strategy to adopt, there’s only one question left to answer. How much time can I commit to studying and following my investments?

    Depending on the answer, we can choose between three strategies:

    • The one-off: passive
    • The warrior’s way: active
    • The Edleson Method: active
    invest strategies

    Differences Between Active and Passive Strategies

    Passive Strategies

    Passive strategies, also known as indexed strategies, are so-called because they try to replicate the performance of a stock index called benchmark. It is a tool developed and published by specialised companies, which investors take as a term of comparison and which meets the following characteristics:

    • objective
    • representative
    • replicable
    • transparent

    Definition

    The benchmark is a portfolio of reference-investments used to determine the performance and balance the allocation of a fund. It is also known as the system’s benchmark index.

    An investor choosing a passive strategy will try to accurately reproduce the benchmark. At European level, for example, the EUROSTOXX 50 was created in 1998, which contains, as the name suggests, 50 stocks belonging to the Eurozone.

    Therefore, if an investor chooses to replicate the EUROSTOXX, it will create their portfolio by replicating the composition of the benchmark.

    Their portfolio will give them a slightly lower return rate than the benchmark index due to the fees charged by the trading platform.

    The passive strategy carries with it the idea that it is not possible to “beat the market“, i.e. to perform better than the benchmark.

    Passive management can be advantageous as it does not require constant changes, and therefore it requires fewer trading costs. Furthermore, you just need to follow the indexes created by experts. At the same time, it will always perform a little worse than the benchmark, due to the commissions.

    Active Strategies

    The active approach to portfolio management takes a different point of view. It follows the principle that you can “beat” the market, i.e. do better than the benchmark.

    This strategy, however, also implies a higher level of risk, that needs to be managed accordingly.

    In fact, it will have to “actively” and frequently change your asset allocation by identifying those financial instruments that have a higher return potential.

    Transaction costs will be higher, but if you make consistent and accurate choices, you can achieve remarkable results.

    No strategy is better than the other: we should just go with the one we are most comfortable with and adapt it to our needs and ambitions. Each of us, for example, starting from passive management is free to deviate from the benchmark by following its own objectives and thus resulting in hybrid forms of management.

    Investment Strategies and Techniques

    The One-Off Strategy

    How to invest

    First of all, arm yourself with patience and nerves. Do not give up at the first signs of stagnation or collapse! The trick is to just forget the money you have invested.

    Generally, you would invest ≤ 20% of your savings. You can do it at once or in 3-5 tranches in order to buy at an average price. The purpose is to secure that capital for a long period.

    For this approach, it is recommended to choose diversified assets, such as ETF or Mutual Funds. Otherwise, you can build a diversified portfolio yourself.

    This formula is convenient for the “Basic” investor who does not have much time to spend on the management of his investments. The One-off strategy requires a preliminary study and one (or a few more) purchase commissions.

    The Technique: What Does It Mean To Diversify?

    Diversifying your portfolio means investing in different financial instruments without allocating all the capital to a single asset.

    Since the returns of the different assets are almost never related to each other, so is their risk. By splitting your capital into a reasonable range of instruments, you can mitigate your overall risk level. Therefore, diversification affects the level of risk.

    “Diversification is protection against ignorance.”

    Here is an example of risk-diversification. The table can be read in a specular way, analysing the diversification according to the asset.

    Another interesting method that follows the principle of diversification is the combination of different strategies. I am not forced to choose between “One-off”, “Warrior’s Way” or the “Edleson Method”. I can segment my investment portfolio according to the three strategies.

    For example, the “One-off” can help me protect my capital as it is low-risk and long-term. Instead, I could use the “Warrior’s way” to achieve steady returns and obtain an alternative income to my salary. Lastly, the “Edleson Method” is perfect if I want to trade aggressively on high-risk and high-yield assets.

    The Warrior’s Way Strategy

    How To Invest

    To choose this strategy you will need to be (or become) a methodical saver, capable of studying and developing an investment strategy.

    You have to be faithful to numbers and statistics, not to the mood of the market. Ignore the sirens when the market drops and keep walking your own path.

    How Much To Invest

    With this strategy, you invest ≤ 20% of your cashflow (profit) every month if you do not have debts. If you have a loan, car payment or other debts, it’s better to invest only ≤ 5% of your cashflow.

    In this way, you will consistently place small amounts of capital instead of immobilising a large amount immediately.

    Remember: portfolio differentiation and consistency are your best allies and will allow you to take advantage of the ups and downs of the market.

    With this method, you will achieve results faster and with greater predictability, even by starting with very small capital.

    Memo

    Even if you may not have large amounts of capital, investing small amounts on a regular basis can be strategic in the long term. In addition, starting at a young age gives you more time to re-invest the potential gains and to overcome short-term market fluctuations. In fact, if the investments do not go as well as we expected, you have time to compensate for any losses.

    The Technique – Operations optimisation

    Each transaction involves a commission, which must be budgeted for in your investment plan, unless you chose the “One-off” strategy. In order to absorb these costs, you need to find a compromise between these two objectives:

    • Invest frequently to spot temporary downs in the market where you can buy more stocks for the same amount of money;
    • Invest large amounts to reduce the weight of commissions to a minimum.

    Since not everyone can afford to invest large amounts of money often, you should identify a reasonable amount and a frequency of investment that does not require too many transactions.

    To this end, take into account the fees for each service in use. For example, your bank may charge particularly high fees for withdrawals to the account of the trading platform you invest in.

    If this is the transaction you do most often with your account, you can look for a bank that offers cheaper fees for this type of use or that provides alternative payment methods.

    Decreasing the number of transactions is one of the most universal laws for any investment system.

    The Edleson Method

    How To Invest

    This type of investor buys a financial instrument in order to obtain a short-term interest by turning the odds in their favour, thanks to the inefficiency of the markets.

    Not only does this strategy allow to tolerate but also to exploit the fluctuations of the market. The Edleson investor estimates the expected value and the real value of the investment to see whether it is time to liquidate or time to buy.

    With this technique, the investor can reinvest all the profit generated, thus accumulating more capital, and to buy when the price of the asset is much lower compared to the average.

    How Much To Invest

    Between 5-7% of your capital. This is because besides the initial deposit, the cash flow is not predictable.

    The initial deposit and the estimated growth rate are very important. These two values will make the difference in times of market crisis and before its recovery. Before starting, assess whether you’ll be able to handle inevitable hard times.

    Remember, compound interest is your best ally.

    This strategy requires some extra effort and to brush up on your Excel skills. You’ll have to stay informed and be able to read the basic tools, such as charts and indicators. On the bright side, this approach opens many more opportunities, especially for those who start with small capital.

    Compound interest

    The golden rule of the world’s greatest investors is always the same: compound interest. None of them spend immediately the money they can generate from an investment. They reinvest it.

    Compound interest is based on an exponential function and the timeframe has a key role for the investment result.

    To make this concept more clear, here’s an example.

    For a new job, we are offered two forms of contract. In the first one, we are paid every day 100€ more than the previous day. In the second case, the first day we are paid 1 cent and the next day twice as much as the previous day.

    Apparently the first contractual formula seems more profitable, but if we look at the development of the compound interest curves, we find out that the multiplier generates much higher gains in the long term.

    Therefore, if we can generate a return of 350€ from a 1000€ investment in Bitcoin in 12 months, following the compound interest we should keep the extra 350€ invested, in order to generate a return on 1350€ the following year.

    In other terms, with a more aggressive trading style, taking advantage of compound interest means reinvesting the initial capital along with all the profit every time a profitable sale-purchase process takes place.

    Where do I buy the assets I selected?

    In order to buy traditional assets and trading online, you need to have access to the Stock Exchange, by opening a trading account with a regulated broker.

    After choosing the most convenient platform, you can also trade on mobile apps.

    The same applies if you want to buy or sell cryptocurrency. If you want to trade, you can open an account on an exchange, such as Young Platform (in case you are a beginner investor) or Young Platform PRO (ideal for expert traders).

    Once you have access to the Stock Exchange or a currency-exchange, the next step is to choose where to allocate your capital. Technical and fundamental analysis of the available assets can be an excellent starting point.

    ETF, ETC and ETN

    Bonds

    Stocks

    Cryptocurrencies

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