Unlike a hedge fund manager or a person with a ‘real’ job, a full-time day-trader needs to consider both his own pay and the returns he earns on his capital. A trader who spends a lot of time trading but has little capital will find that his ‘hourly wage’ is so low that he would have been better off not trading.
So unlike hedge fund managers or investors, I measure my performance in terms of imputed wages and return on capital. I have a minimum hurdle rate on each that I must meet to justify my continued trading. First, there is my imputed wage. As an intelligent and well-educated person with a good work ethic I could be expected to make a good wage at a real job. That being said, I have essentially no job/career experience and my education (an M.A. in cognitive psychology) is essentially worthless. After finishing my Master’s degree in mid-2007 (before the financial crisis came to a head) I succeeded in landing only one job interview, for a $33,000 per year dead-end job crunching data for the St. Louis Fed. I was not even offered that job. I ended up working for an acquaintance’s start-up company for low pay plus equity but left that after half a year to trade full-time.
Realistically, I would not expect to be able to make more than $30,000 per year if I were to get a ‘real job’. However, I am confident that I could grow that amount to over $50,000 within 5 to 10 years. Consequently, I set my ‘imputed wage’ at $50,000 a year. Obviously a real job would have fringe benefits that would add value, but I assume that the benefits of trading, such as working for myself and not commuting and saving money on work clothes, roughly equal the fringe benefits I would otherwise receive. I subtract this imputed wage from my annual trading earnings before considering my investment performance.
Return on capital (annual percent return) is an important measure of return. However, you cannot buy groceries (or lunch at Per Se) with percent returns, only with dollars. So the smaller the capital, the less meaningful percent returns are in the real world. However, because I calculate an imputed wage that I subtract from my trading profits, when computing return on capital I only need to concern myself with percent returns and earning a decent return on my capital. Now, any good analyst knows that cost of equity is determined by the riskiness of the business (or trading strategy). So what is an appropriate cost of equity?
I think that it is a bit silly to calculate an exact cost of equity (the minimum investment return that is acceptable) as analysts do with public and private companies (see this slideshow on how to calculate them). A few important things to consider that will increase the cost of equity for a trader are: high maximum drawdowns, increased frequency of drawdowns, fewer trades, longer trades (swing trading), larger position sizes, use of leverage, and return volatility. My particular method of trading penny stocks, because I never hold very long and keep my position size small both in absolute terms and relative to my capital, means that my cost of equity is low relative to other trading strategies. I therefore set my annual cost of equity at 10% compounded. What I mean by this is that if I do not make my 10% in one year I feel the need to make up the difference the next year. Compared to an expected return of maybe 7% to 8% for a buy and hold portfolio of stocks (with large drawdowns) this seems reasonable. My trading strategy is much lower risk than the market portfolio. I can say this because so far this year I have not had a negative month. In fact, in 2010 I only had one negative month, when I lost $1579 in March 2010. Below are my monthly returns since 2010:
For those of you with a basic understanding of computing compounded returns, you can calculate that my time-weighted IRR for 2011 is 21.98% so far. To calculate my return minus my imputed salary I simply subtract my monthly imputed salary $4167 ($50,000 / 12 months) from each month’s dollar return and then calculate and chain the new percent returns to get my time-weighted post-salary IRR. This is at 13.87% for the current year, so I have made an acceptable return so far. Obviously I aim to generate higher than just acceptable returns, but my goal as a full-time trader is not to generate the highest return possible but to generate good returns while minimizing my risk. Over the last two years I have done that quite well.
The problem of too much capital
I have a large amount of cash in my trading accounts. This obviously reduces my returns because I keep my position size tiny and I have not even come close to using all my capital in the last year or two. Most professional full-time day-traders that I know prefer to keep their trading accounts relatively small so as to minimize the urge to take overly large positions. Due to my personality I have no such urge so it does not harm me to keep extra money in my trading accounts. Because of this I can also avoid having a separate emergency fund–I know I always have plenty of cash in my trading accounts. Also, with bond yields so low over the last couple years there is little opportunity cost to keeping so much cash. That being said, my percent returns have been juiced the last few months by a large withdrawal I made from my trading accounts to buy a house with cash. While it may seem silly to pay cash when mortgages are at 4%, by paying cash I reduce my overall leverage and earn a guaranteed 4% return on money I wasn’t really using anyway.
For those with too little capital
The problem of too much capital is very far from most trader’s problem of having too little capital. I see so many people trading and spending lots of time trading, with $5,000 or smaller accounts. If that is all the money they have it seems foolish to spend a ton of time learning to trade if that requires them to neglect a day-job. While I have known some people who have built up such a small account, it is very hard to do. Now if someone starts trading with such a small sum of money but can increase his account size after he has learned to trade and become profitable, then that is a very smart thing to do. And if a trader can trade without impairing his job performance or by utilizing free time, then that is also fine. But I am sure that many people who try to trade with small amounts of capital would be better off putting the effort into improving their career prospects. It would be a poor tradeoff indeed to sacrifice the potential for large salary increases just to obtain a few thousand dollars in trading gains.
That being said, one benefit of having a small amount of capital is that a trader can take much more risk. For someone with a $50,000/year job and a $10,000 trading account, a 50% drawdown is not nearly as big a problem as it would be for me. That person can easily save enough money in a year to bring the account size back to where it was.
I encourage reading of Investment Performance Measurement which is a great book on all the nitty-gritty details of exactly measuring performance and calculating different types of IRR.
For calculating my time-weighted IRR I simply do it by month using my monthly starting capital in all my accounts and then dividing my monthly return into that figure, chaining the resulting monthly percent returns. I withdraw money from my accounts over time so by not breaking my performance down into smaller time periods separated by each withdrawal my calculated performance ends up being slightly lower than my real performance. To reduce the data entry work this is an acceptable short cut. Somebody gradually adding money to his trading accounts would inflate his calculated performance by not properly accounting for the deposits to his trading accounts.
Those who add or subtract money from a trading portfolio that is not in substantially all cash should also compute their money-weighted IRR to determine if they are adding or subtracting value by changing how much money is in their account/portfolio.
One last note
My monthly performance numbers do not include non-commission broker costs or other costs. These should add up to a few thousand dollars this year.