As traders, we like to get waaaay ahead of ourselves in the race to understand and exploit the financial markets. One symptom of our eagerness is often wrongly assuming that more complexity = more profit.
This assumption can lead us down long and unnecessary rabbit holes and away from the more mundane fundamentals that account for 80% of our day-to-day trading decisions.
When you run a trading business you quickly get to the meat of practical market theory – the 80-90% that matters. From our experience, there are two fundamental concepts you need to know that are absolutely vital to profiting from the markets.
These concepts are:
- The Time Value of Money
- The Principle of No-Arbitrage
This post is the first in a series of Quant Basics where we’ll explore these fundamentals, as well as others. We’ll focus solely on the Time Value of Money today as it’s the cornerstone of any profitable trading approach…. including what we do here at Robot Wealth!
So down tools on those deep neural networks for a second. Let’s look at why this first concept is so important for your success as a retail trader.
The Time Value of Money
This is easily the most fundamental concept in finance — let’s break it down.
Simply put, $100 today is worth more to you than $100 received in a year’s time. Call me captain obvious.
If you have $100 today you can do potentially valuable things with it now. You could start a business, or you could invest it in a financial asset like a share of a company. By doing this you expect to get positive returns on your $100 for taking on this risk, so it seems like a good idea that is likely to pay off over the long-run.
But what if you don’t have a long-run?
What if you are going to need that $100 in a year’s time and you want to make sure you preserve that capital, but you also want to put it to work to make more money in the meantime?
In that case, you can lend it to someone who has a slightly longer investment horizon than you. In exchange for them having the use of your money, they will pay you a small amount of (theoretically) guaranteed interest when they give you your money back.
This is what your bank does. When you deposit money in the bank, you’re really lending it to the bank. They take various well-diversified risks with that money and they pay interest to their depositors for the use of that money. If they manage things appropriately they will receive a return greater than the interest they pay to depositors – producing a profit.
This simple idea that money has a time value is fundamental to all of finance.
What’s in all this for you?
Well, if you have money now you can use it to make more money in the future if you know what to do with it.
(Stuffing your money under the mattress is a poor choice when someone with ideas and plans is willing to pay you for the use of that money…)
The Time Value of Money principle gives us a baseline for our risk-taking. If we can get a certain guaranteed yield in the bank then we should only be taking on extra unguaranteed risk if we are confident that our expected rewards for taking that risk are greater than the baseline amount we get from the bank.
In essence, trading is risk-taking.
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What’s a simple way for you to earn over that baseline amount?
As investors, we are rewarded for taking on certain long-term risks, which include buying assets that are sensitive to disappointment in economic growth, inflation and interest rates. Here are some risks associated with various financial products:
So to put our capital to work we get long assets which are exposed to these risks. Getting long lots of them dramatically reduces portfolio volatility through diversification – which is a good idea!
We primarily do this by harvesting risk premia.
In extremely simple and general terms:
- Buying stocks is a good idea
- Buying bonds is a good idea
- Buying real estate is a good idea
- Selling a little bit of volatility is a good idea.
By getting those in your portfolio you buy yourself the maximum chance of making money under most conditions. This also adds a portfolio “tailwind” to your active strategies.
Crucially, this also means that you’ll always be trading one way or another, even when your more active strategies inevitably stop working….which will happen.
We incorporate this in our trading at Robot Wealth. Our risk premia strategy has returned around 17% at a CAGR of 26% since going live 9 months ago:
We provide this strategy to our Bootcamp participants, too
You can read more about why and how we harvest risk premia here.
How hard is it to pull off?
The good news is that there’s no need to make this approach more complicated than it has to be — 80% of success here is just showing up.
The precise way you execute the above risk-taking matters a lot less than the fact that you do it at all. If you find technical details like volatility and covariance management daunting, know that this makes up just 20%.
The 80% is just buying the right assets and keeping hold of them – which is simple to understand and implement, and will put you in a strong position when you get involved in more active, riskier trades.
Harvesting risk premia is a simple way of taking risk to earn above-baseline interest on your capital, especially as a small-time retail trader. It’s the most sensible way to use the time value of money to your advantage, before getting involved in more active strategies. You just need to show up and have a long time horizon.
That’s Quant Basic number one.
In the next Quant Basics post we’ll investigate the pricing efficiency of the markets, why it’s hard to trade given this efficiency, and how you can do it anyway!
In the meantime, you can learn more about the fundamentals of algo trading by downloading the free PDF below:
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