This is a discussion I try to work into all my one-on-one mentorships. There isn’t a right answer of course, but the objective of the exercise is to layout a few possibilities and help each trader make a more informed decision.
Perhaps the most common response, particularly at the outset when your fledgling account begs for bigger numbers, is to leave any all profits in the portfolio to
Let it Compound
First, as the account grows the drag of commission diminishes. A $6 round trip commission cost in a $3k account creates a much stronger headwind than in a $30k one.
Second, you can exercise superior risk protocols with a larger account. It’s virtually impossible to risk 1% per trade in a sub-$5k portfolio. Small fry traders must of necessity risk a greater percentage of the portfolio to compensate for commission and to make the endeavor have any chance of moving the needle. But, in doing so, they face a greater risk of ruin.
The third is related to the second – it’s easier to diversify and rack up a large enough sample size to see the edge of a particular system play out. As mentioned previously, we can make a strong case that more trades is better than less. But that’s hard to achieve in a tiny account. So let the money compound.
I can think of a few disadvantages to continuing to compound in a single account. The first is psychological.
The Fear Factor
The same percentage gain/loss in a large portfolio feels different than a small one. Even though they have the same impact. You will likely feel more pain seeing a $100k portfolio drop 10% than you will with a $10k portfolio dropping 10%.
Psychologically I find the idea of managing three different accounts of $50k each easier than playing with a single $150k account. And that’s even if they are all risking 1%. With the $150k portfolio, you have to cope with much larger dollar amount fluctuation. 1% represents $1,500. For some reason, if I have the same position spread over three accounts where each is risking $500, even though it’s the same risk it feels different when I can compartmentalize the pain across multiple smaller accounts.
Maybe I need to have my head examine. Or perhaps this is a common bug among all of our wiring.
Chalk this up as one of the benefits of NOT compounding. You may find it less taxing on the emotions.
And speaking of taxing…
Tax Man
A second disadvantage to compounding in a single portfolio is it doesn’t allow you to open other accounts that offer tax benefits. I’m talking about things like an IRA, ROTH, Solo 401(k) and the like. This assumes, of course, that you are currently keeping your dough in a margin account to grow.
Trader A may save a few thousand bucks in a single margin account and keep all growth in it to compound
Trader B spreads his money into a margin account, ROTH, and Solo 401(k). Furthermore, at the end of the year, he scrapes all gains in the margin account off the top and re-allocates them into his retirement accounts.
In an ideal world, Trader B would make enough profit in the margin account to fully fund his retirement accounts. Nothing like using portfolio gains to sock money away instead of earned income, am I right?
Diversification
It is this diversification benefit that I think speaks the loudest to my conservative soul. I’ve heard too many horror stories of traders building up large accounts through the power of compounding, only to give it all back in a blaze of busted trades.
If you’ve yet to come across such a tale, I suggest this one.
My Solution
What I’ve found works well for me is using my margin account for the most active and aggressive types of systems. Then, I relocate gains (when I have them – sometimes I don’t… sadly) regularly to more conservative accounts. My wife and I both have ROTHs, and my business has a Solo 401(k). That allows for plenty of flexibility in deciding how much to allocate into pre-tax or post-tax accounts. Ideally, I fully fund everything every year.
In summary, job number one is figure out how to make money. Job number two is to create a strategic plan for allocating gains.
2 Replies to “Tales of a Technician: What Do you Do with Profits?”
Managing more smaller accounts is easier psychologically as you say, but a small % stoploss may still represent what we consider to be a large dollar amount, but adds a degree of complexity because you have to cycle between accounts — I find myself placing the same trades on both, trading mostly the same tickers, and then even using stop losses that are at the same or similar price levels but use different levels of allocations (shares or contracts) depending on % allocation rules. With margin I still use some more advanced techniques that are not possible in IRAs, so they typically are never going to be exactly the same (to make good use of margin), which also adds complexity.
I love it. Super helpful post.
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