Saturday, December 02, 2006

Low capital investing

There was an excellent piece written on Move the Markets (sourced from Trader Mike) on the risks of under capitalization and trading. Unfortunately, for many people who have day-to-day jobs (myself included), allocating large sums of money necessary to capitalize a trading account is simply impossible. Even for those individuals with money to fund trading accounts, capital restrictions in special accounts like ROTH/IRAs mean maximizing the benefits of these accounts requires special thought.

So how can one work the market with a small sum on money?

The following is a quick-and-dirty analysis on a couple of strategies available for low capital accounts. As Move the Markets highlighted, commissions are the biggest killer of small accounts. There are alternatives, such as zero commission brokerage firm Zecco. But the consequence of this could be stripped down services(?)[I can't directly comment about the usability of Zecco]. Other alternatives include the dollar-cost-average services provided by BUYandHOLD, Sharebuilder, and more recently, SogoInvest.

For the purposes of this article I am using examples of allocating $100, $200, $300 and $500 per month (or annual allocations of $1,200, $2,400, $3,600 and $6,000). The stock examples are taken from my free service; the first pick for the first day of the respective months from November 1st 2005 to the end of October 31st 2006. Recommended stop and target prices provided are used, adjusted to account for dividends and splits as provided by historical data. I must add, the spreadsheet calculations used are not perfect, so allow for some wiggle room. Also, for the Ameritrade example I have rounded the shares bought to the nearest whole number, which adds an additional level of error.

First up we have the $100 per month / $1,200 capital allotment. Given the level of risk, the dollar-cost-average (DCA) return was disappointing at +5.14% compared to the returns if it had been left in the bank to earn 5.05% (using an HSBC e-savings account, assuming the interest rate earned remained constant for the year) with commissions (assuming a basic Sogoinvest account) accounting for 3.8% of the return, but DCA did outperform saving using drip payments into a savings account (+2.4%). The regular Ameritrade account had a good year with a +14.68% return with commissions accounting for 7.11%.

Obviously, it helped having a good start with AAUK and had we started with a few more losers then the DCA account would have been hit harder because of the commission costs; compare the returns of the stop hits from DCA to that of the sample Ameritrade account: -12.86% vs -7.70%, -9.94% vs -4.78%, -15.97% vs -11.05%. Ouch!

Doubling the amount invested to $200 monthly or $2,400 annually, sharply improved the DCA account as the higher base amount helped offset the commission costs from the losers. The +7.14% return was better than leaving the money sit in a high interest account and improved the return by 39% over the $100 monthly contribution. Interestingly, the Ameritrade account didn't change too much, improving the return by only 14%.

Going to $300 per month, or $3,600 annually didn't alter the picture too much. Given the 50% increase in contribution from $200 per month the change in return for the DCA was a measly 9.0% and the regular account improved by 7%. The slow down in the gain rate is attributed to the lower impact of commissions on the base returns; now amounting for less than 2.5%.

The final leap to $500 per month, or $6,000 annually improved the DCA by 6.6% and the Ameritrade account by 6.3% over using $300 per month, or $3,600 annually.

Assuming the availability of high rate saving accounts and/or low risk yield plays it is better to protect your capital in such instruments if you have around $1000 available to work. When commissions (depending on your brokerage company) account for 2% or less of your total capital you can consider investing in stocks. Compounding your returns through the use of a traditional trading account outguns the drip contribution method of dollar-cost-averaging, but leaves your outgoing capital exposed to early losses which become harder to recover from.

For those who work outside of the market for a living, dollar-cost-averaging is the way to go. You are less vulnerable to wipeouts and if you have a series of losing stocks your capital hit is less (but ensure you have a sufficient monthly contribution to offset the commission hit). This is only one example - one would need to repeat this using different stocks say if you were unfortunate to bank a series of losers.

The other point of the dollar-cost-average method which I have not accounted for is the benefit of buying more shares when the stock falls. Obviously, one would not want to buy a stock all the way down from $$s to pennies, but it would give you more leeway for stop placement - which could be looser than might otherwise have been used if all capital was allocated to a single trade; using a weekly or point-n-figure chart support would be a good place to look for a stop price in this regard.