I have been reading around a number of different general financial blogs and inevitably the discussion of what is the “best” investment formula pops up. You then see a tirade of oh you should put X% into stocks and Y% into bonds, countered by another poster saying you should put A% into stocks and Z% into real estate. The debate then goes on and on and on.

I get tired of these endless arguments about asset allocation, because they usually miss the point. Your asset allocation strategy depends on your objective. If your objective is wealth creation then you do a totally different strategy from what you might do in wealth preservation.

Wealth Creation vs. Wealth Preservation

Most of the books you buy at the book store, or the advice you get from your financial planner or the advice your Grandma gave you about investing is all about wealth preservation. For wealth preservation you don’t need an information advantage. You just need to diversify your assets among the usual instruments such as cash, real estate, bonds and stocks (e.g. using index funds, Value line, or Berkshire Hathaway).

Wealth creation is a totally different beast. It is about specialization and taking a calculated risk on something which you have an information advantage in. It could be about day trading, flipping real estate or selling online.

Wealth creation is about picking something that you know intimately and pushing yourself one or two steps past your sleeping point. If you can sleep well at night, you are probably not taking on enough risk (OTOH if you are a nervous wreck and haven’t slept well for days you are over doing it – you need to find the right balance).

Toyota knew this and this is why the US car industry is no longer the industry leader. The US car industry spent its whole time trying to perfect the process of manufacturing cars. It was very expensive and ended up with cars with far too many bells and whistles and a big price tag. The Japanese worked on a different paradigm, The Japs simply just sped up the production line and when something broke they fixed it and got on with the job of producing new cars faster and cheaper than anyone else. You need to have the same mind set with wealth creation. Pick something that you have a passion for and feel you have an information advantage in and then find a way of speeding up the process. This might mean, for example, quitting your day job to flip houses full time.

in addition to: “Picking something that you have a passion for and feel you have an information advantage in and then find a way of speeding up the process” you need to think about how you can do this in as few hours per week as possible. For example, if you quit your job to do up and flip houses for a living, you have just replaced a 40 hour work week with a 80 hour work week. Sure you will make much more money, but your quality of life will go down. What you really need to think about is how you can speed things up using the principles of:

• Finding ways to eliminate the unnecessary;
• Automating those things that are best done by a computer; and
• Delegate parts of the process that don’t need your direct involvement

Why am I saying this?

All of this is highly applicable to trading. Trading is fundamentally about “wealth creation”.

Firstly, trading is not about trying to equal the index of managed funds or the S&P 500 using some diversified stock portfolio. It is about being able to trounce the index using some specialized knowledge that your average fund manager does not have. So when some trading book tells you you should aim to make 20 – 30% a year put it down. You are reading an investment book on wealth preservation. You should be shooting for at least double.

Secondly, if you don’t have an “information advantage” in trading, you really don’t have an edge that can be used to create wealth. Without an information edge you are just gambling. This is why trader invests so much into their education as it is their education that gives them the information advantage.

Third, trading is about adopting the Japanese philosophy of running the production line faster. It is not about trying to make the best cars in the world. So trading, isn’t about agonizing over picking a buy and hold portfolio of the world’s best stock, it is about finding a repeatable edge and exploit it over and over and over and over and over and over and ………. and when the production line breaks you fix it and get back to cranking it up again.

Finally, trading is about being time efficient. You need to eliminate all waste from your trading. For example, if it doesn’t help you to spend hours and hours reading every posting on forex factory then STOP IT. Similarly, if you can find some way of automating part of the trading process then you should pursue it. Lastly, if you can find some way of delegating part of the process of trading out, then you should adopt it. For example, if you can find a service that is better at technical analysis than you, perhaps you should consider subscribing to it.

When you start thinking more about being more time efficient in trading, you start to realize that your job as a trader is really that of a production line manager. It is about plugging together a production line of advisory services,trade management tools, and risk analysis tools and then working on continuously improving the profitability and risk profile of that production line. At the end of the day it is this production line that becomes your wealth creation machine.

Now, once you have your wealth creation machine going, what next?  Well of course you take part of your profits and sink it into your wealth preservation machine.  Why do I say this?  because you don’t want to be trading when you are 70.  You want to retire long before that point and enjoy the fruits of all those sleepless nights.

This entry was posted on Tuesday, November 4th, 2008 at 10:01 pm and is filed under Financial Planning. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.