It's all about the curve – Part II

Nobody wants their finances to grow in a straight line (too slow, and inflation really hurts), so let’s continue this series with a look at a faster way to grow your money … one that is well covered in mainstream personal finance blogs:

The Compound Curve

When we do one simple thing [AJC: again, ignoring the effects of inflation], the whole picture changes dramatically:

If, instead of withdrawing/spending the interest earned on the CD, we ask the bank to reinvest the interest then we create an effect known as compounding. Where both the principle (i.e. the lump sum that you originally deposited) and the interest (then the interest on the interest and so on …) earn interest. The effect, as you can see, can be quite powerful … slow, but powerful.

In fact, ‘urban legend’ has Albert Einstein calling compounding “the most powerful force in the Universe” … urban legend because Einstein would never have called such a relatively [pun intended] slow geometric progression ‘powerful’ when he had nuclear reactivity to play with (a far quicker and more dramatic form of compounding).

Be that as it may, compounding is something well understood, but always remember that it is only powerful to the extent that it may keep you out of the ‘poor house’ – but, not by much – hence, compounding is really only a basic (but necessary!) Making Money 101 saving strategy:

- without it, you don’t get to first base, financially-speaking, but

- with it, that’s about all you do.

You can – and probably already do, to a greater or lesser degree – apply the power of compounding to your job/profession (be it as paid employee or paid consultant) when you reinvest some of your earnings into investments such as mutual funds (e.g. via your 401k), direct stocks, and real-estate … and, of course, reinvest (instead of withdraw and spend) the dividends (a.ka.a ‘profits’) from those investments.

What does poker have to do with investing?

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Warning: This is a High Risk Post … it’s only for those poor misguided souls who INSIST on speculating (be it: stocks, real-estate, FOREX, commodities, etc., etc.) … don’t do it! But, if you MUST try to gamble your way to a fortune (admittedly, it has – albeit RARELY – been done), at least read on ….

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I have a confession to make: I love playing poker.

I had never played a hand – nor gambled at all (I hate any game where the casino odds are even 1% or 2% against me … why throw money away?!) – but, then I arrived in the USA and turned on the television just as Chris Moneymaker was bluffing Sammy Farha on his way to making history at the 2003 World Series of Poker  …

… it was like meeting the eyes of a woman across a crowded room; it was (I am ashamed to admit) ‘love’ at first sight

Which brings me to the Universe’s Cruel Joke, and it goes something like this:

I exclusively play No-Limit Texas Hold’em but met a friend who is one of the world’s top Pot Limit Omaha pro’s … in fact, I now take tennis lessons with him. This (not him!) convinced me to give the game a try, so I throw $40 (being sensible, no need to throw ‘real money’ away) into an online table while I’m chatting to a friend over the ‘phone and what do you know, I’ve made $200 about 3 minutes later!

This is a game I could grow to love, so I proceeded to lose $4k over the next few weeks, playing my usual limits …

… oh, I know this is just ‘variance’, because I’m in with the best hand almost every single time

Which brings me to Josh:

Josh is one of our 7 Millionaires … In Training! and he intends to make his money trading according to a system that he has been developing for trading pharmaceutical stocks. I have high hopes for Josh, and he will probably end up with his own hedge fund, if he survives his good luck.

You see, Josh has just hit it big – and sudden – as, he explains:

My net worth increased over 1200% on May 7. Check out my networth profile I updated recently.
https://www.networthiq.com/people/jaushwa

[I put] the whole 401(k) and personal brokerage account into a penny pharmaceutical stock, (avg price was around .0475 cents.) Today it closed at .82 cents. The stock is TTNP, Titan Pharmaceuticals.

Adrian, when are we starting MM-201, I’m jumping out of my skin here?

As I said to Josh:

If you MM201′ed any harder, you’d burst

You see, it’s easy to make money when you find a stock that climbs straight up like Jeff’s Hornet on full after-burners, it’s MUCH harder to:

a) Repeat until rich, and

b) Keep it, once you’ve made it.

What has this to do with poker? More importantly, what does poker have to do with investing?

Well, if you are a trader/speculator … everything!

You see, poker is a high ‘variance’ activity – that means that there is both a skill and luck component – but, you may know this as high risk / high reward. And, the best friend of the professional poker player is not skill … or even having luck on their side … it’s bankroll management.

At its simplest, ‘bankroll management’ means not allocating too much of your bankroll (i.e. capital) to any one session, and walking away when you lose that … at its most complex, it can involve a whole set of rules, such as Chris Ferguson’s poker bankroll management system …

… Chris is a top poker professional who – as his own ‘grand experiment’ – set out to make $10,000 starting with just one penny. Even though he had great skill – far greater than any of his opponents at the levels that he was playing at – he knew that he needed to protect himself from that devil known as ‘variance’ (i.e. sheer bad luck):

Here’s how he did it:

Starting with nothing but a Full Tilt Poker account, Chris played in Freerolls until he earned enough to graduate to games with real-money buy-ins. From that point on, he adhered to a strict set of guidelines to build up his bankroll:

• He never bought into a cash game or a Sit & Go for more than 5 percent of his total bankroll; the only exception was at the lowest limits: he was allowed to buy into any game with a buy-in of $2.50 or less
• He didn’t buy into any multi-table tournaments for more than 2 percent of his total bankroll; the only exception was $1 MTTs
• If at any time during a No-Limit or Pot-Limit cash-game session the money on the table represented more than 10 percent of his total bankroll, he had to leave the game when the blinds reached him

Getting started wasn’t easy. In fact, it took more than seven months of steady play until he got his bankroll to stabilize at about $6.50. Undaunted, Chris maintained his discipline and dedication and continued with his challenge. Then, on November 26th, 2006, Chris made a major breakthrough. He turned a $1 tournament buy-in into $104 in prize money when he finished second in a 683-player tournament. Even with that huge bankroll boost, it still took Chris nine more months of hard work to reach $10K. But because he strictly adhered to the bankroll management strategy that he’d set for himself, Chris achieved his goal the following September.

Besides the sheer similarity in Josh’s and Chris’ graph, there are clear parallels between poker and trading … if you still can’t see them, stop and play a little $1 / $2 no-limit hold’em online … you’ll begin to see my point, pretty soon

What has this to do with personal finance??!

Well, for traders and speculators,’bankroll management’ – which we call Making Money 101 – is also the most important skill that you need to learn so that you have a base to work from and a fall-back …

… if you are still not 100% convinced, I would encourage you to grab the book about Jesse Livermore – The World’s Greatest Trader. I want you to see that he became rich and broke FOUR separate times (then, blew his own head off) … I don’t want this to happen to you.

Once you really FEEL this, read on – otherwise, just bookmark this post and wait … nothing produces discipline better than the inevitable major loss …

OK, if you are now TRULY ‘on board’, I want you to break your ‘windfall’ into three easy (well, equal) pieces:

1. Trading Account: do more of what you just did, and hope to repeat (just remember NOT to put all of your position into one investment … ONLY invest into one ‘event’ what you would be happy to lose 100% of without suffering unduly)

2. Passive Investment Account: Buy a rental; or buy/hold ‘boring stocks’ that you would be happy to own forever … fight the urge to trade these stocks!

3. Savings Account: This is what you live on (assuming trading is your major source of income), keep this in cash or CD’s. I told Josh to use this as a deposit on his own condo.

When you lose 1. (almost all poker players – and traders – lose their ‘bankroll’ at least once in their lives … some MANY times a.k.a. Jesse Livermore) forget about ever ‘dipping’ into 2. or 3. to try and ‘catch up your losses’ … it won’t happen(!): you will simply have to go back and build up a new trading account from scratch … just like you did when you first started out.

Always remember this ‘3 easy pieces’ approach to windfalls and you won’t ever go [completely] broke …

Rich 1; Broke 0; Head [Intact] – not a bad scoreline

How much money can you amass living frugally?

The answer, of course, is a lot … especially if you consider $1.4 million ‘a lot’ … and, who doesn’t?

KC (a regular at my new reader community: www.sharyournumber.org) sent me an e-mail asking:

I saw this article: http://www.stltoday.com/stltoday/news/stories.nsf/stlouiscitycounty/story/95052F7B696733CA8625759500189E1C?OpenDocument

[the headline reads: "How social worker Jane M. Buri saved $1.4 million, then gave it all away"] and I can’t begin to think how you could start to calculate whether this is indeed possible for a moderately paid social worker who lived frugally.

What are your thoughts?

Well, on the surface the lady appears to be a classic miser; she:

- never married, never had children, never missed a day of work

- drove a 30-year-old car, watched an ancient TV (she resisted replacing her old TV and icebox), lived four decades in a house bought with cash in 1969 (the furniture was her parents’)

- dressed plainly, wore costume jewelery, dyed and permed her own hair

- would buy five sandwiches for $5.95 from Arby’s (she’d eat one and freeze the four others for later; when she went out with friends, they nearly always split the bill)

I think this statement sums it up the best:

She lived, her friends say, nearly as a nun.

On the other hand; she also ‘lashed out’ from time to time; if you call eating out ‘lashing out’:

Nor did she deny herself small indulgences. Some weeks, she ate out three meals a day, friends said. She traveled to Europe, and to the Rose Parade in California. She bought a baby grand piano.

OK, this is a lesson in frugality: single woman, no mortgage or car payments for thirty years and 100% gainfully employed living frugally …

… does this mean that it’s surprising how much she managed to leave behind?

Well, we have a data point:

She got her first job as a social worker in 1954, according to St. Louis Public School records. She made $3,800 a year. Within 10 years, she was running the department and had doubled her salary.

Let’s assume that she grew her salary from 1964 until 2002 at 6% p.a. (which leaves her a finishing salary in 2000 of nearly $61,000); let’s also assume that despite her frugal habits that she still spent / donated half her money (after all, there “was nothing she wanted and didn’t buy” and she “kept stacking charity donation envelopes in her sun room, until, once a year, she sent them all in”) … which all means, that we are assuming that she saved ‘just’ 50% of her salary.

Putting this all into a spreadsheet (with the final assumption that she just managed to earn 6% on her money, compounded over the 50 years that we are talking about), I can see that $1.4 mill. is reasonable for her to leave behind; in fact – by pure coincidence, because of all the assumptions that I’ve made – that’s exactly what I came up with at my first attempt at running the numbers.

There’s no doubt that living this frugally for 50+ years, having no major expenses (family, house, car, etc.) is the secret to this kind of financial ‘success’ … she apparently enjoyed the life of a ‘nun’ … so might others … would you?