How much capital is required?

It is ironic that generally the less capital novice investors have the more risk they take. They focus on higher risk trading instruments or higher risk trades seeking the large quick returns. Besides the additional volatility risk, they then magnify that risk by allocating too much capital to these high risk trades and in many cases leverage. Too much is a relative term. It is this very mindset that leads to most novice investors losing in the market. In fact, lack of capital is one of the biggest reasons why most novice investors are “taken out” by the market.

With more capital, more opportunities can be traded which, in turn, through compounding, can increase absolute returns if the active investor knows how to manage the risks, has the discipline to follow the rules and allocates capital according to the risks being taken. More capital will also allow the active investor to sustain a number of consecutive losses (provided they can handle the loss trades psychologically).

So how much is more?

I recommend that anyone trading in a medium term time frame (average hold period of around 8 weeks) should start with a minimum starting capital of A$50,000 but preferably A$80,000.

The main reason for A$50,000 being the minimum is the minimum brokerage that is paid to transact in the market. In Australia, assume a minimum brokerage of $30 or 0.15%, which ever is the greater, a trade size of A$2,000 would incur brokerage of 1.5% of the position ($30 ÷ A$2,000).

If a trading system averages 4% movement per trade (excl. brokerage) then the buy and sell transactions would use up 3% leaving just ¼ of the gross profit for the trader with the broker getting ¾ of the gross profit. You can change brokers to reduce your brokerage but there is a limit to how low you can reduce your brokerage rates. The answer is to increase your trade size which means you need to increase your trading bank.

As a rule of thumb, ensure that your brokerage doesn’t exceed 0.35% per transaction, on average across your various position sizes, or 0.7% per trade (i.e. both buy and sell).

The general rule should be the less amount of capital you have, the more passive your strategy should be. The more capital you have the more active you can be (if you choose).

An approximate upper limit on medium-term trading capital would be around A$800,000 to A$1,000,000 per portfolio in the Australian market due to liquidity reasons. Basically, with larger amounts of capital, it is suggested that:

1. two or more portfolios are established,
2. capital be allocated to other market strategies that are lower risk and require less effort (and achieve lower returns)

Otherwise the only limit on capital that can be used for medium-term active investment is imposed by the liquidity of and the number of stocks on the exchange being traded.

There is, however, a school of thought that if you trade a system that over time continues to provide excellent returns, then you should commit as much capital to that system as you can possibly lay your hands on, market liquidity permitting!