Conserving Capital

The financial markets have seen many a day-trader who has lost his money in the business. Most of those who have lost money would in all probability they entered the trade because they were impressed/tempted by seeing some of their other friends making quick bucks or becoming rich overnight. And it is mostly the day trading which brings out exiting results which can be publicized.

A strong indicator of this “fuelled by adrenaline philosophy” is the volume in the derivates market in India. This volume is higher than the cash market by a ratio if 2:1. This means that there are more speculators in the market than the actual buy-and-hold people.

Kural 463 says:

 “Akkam Karuthi MudhalEzhakkum Seivinnai
Ookar Arivudai yar”

The translation goes like: “People with wisdom will not take actions that reduce their capital in anticipation of returns that could come later.”

How  Derivatives trading happens?

Derivatives give traders a major benefit in the form of leverage. Financial Leverage is basically any action that can mobilize larger resources by using lesser resource. Levers are powerful. It was Archimedes who said, “Give me a long enough lever and a fulcrum to place it and I shall move the World”. Derivatives leverage a small payment in the form of a premium (option) or margin money (futures) to trade in a “Lot“ which is typically 10 to 50 times larger than the payment.

For example with a small bet (margin) of Rs.25,000/- we can buy and sell a ton of copper worth Rs.430,000/- (one lot). Even a small 1% profit on the lot is Rs.4300/- which is a huge 17.2% profit on the margin.

The Down Side

The down side is that the loss is also highly leveraged. Remember the leverage works both ways. If there is a small loss of 1% in the Lot trading, we lose a huge 17.2% of the CAPITAL. This happen by default there is no way that we can postpone the capital erosion. To do the next trade we will need to bring in more CAPITAL. Kural  463 points us to exactly such a condition.

The Stock Market is Different  

The structure of the stock market is different from the derivatives market. Here when we buy a share, it remains ours. The value of the stock may go up or down because of the way the company performs and also because of the market as a whole. But the stock that you own remains with you. 100 shares of XYZ company never decreases to 75 shares of the company by itself.

To book a loss or profit, we have to actually sell. Till then the loss or profit is only on paper. That way we can hold on to a stock till we make profits. Or buy more to reduce the average price or invest in it in a systematic manner to make use of cost averaging. The SIP (Systematic Investment Plan) of Mutual funds and monthly mode of premium for insurance plans perform the cost averaging for us by making investment on a monthly basis.

The Cash Flow Concept

Robert Kiyosaki in his book the RICH DAD, POOR DAD, introduced the cash flow concept for asset definition. He says that only those that give a positive cash flow can be classified as assets. The rest are liabilities. The Kural 463 also is in similar lines, when it talks about losing capital in anticipation of returns latter.

There are many large businesses that have gone bust because they have not followed this principal of protecting their Capital. Most of the banks that went down due to the sub-prime crisis in the USA and the European Union fall in this category.  

The Kural is also a wake up call for all those who procrastinate in anticipation of things settling down sooner or latter, for time is an asset that is totally non-renewable. And it is all the more important with matters pertaining to financial investments as it could mean the difference between being a millionaire and going bankrupt.