Relative Efficiency of Return on Investment with Trading Comparing to Other Businesses

I wrote in my blog two weeks ago about trading income which somehow generated quite a number of emails asking for clarifications of what I mean. So here it is again on the same topic with examples to illustrate the point. This should allow people who is interested in starting their own businesses or in learning to trade to understand better the advantage of trading as a business from financial standpoint.

Relative Efficiency of Capital Deployment

What I wrote in my blog outlines the profit potential of trading relative to running other types of businesses. I did not use exact figures at the time as it was written based on my conversations with some people asking about trading. Hence it is done with examples that those people can understand. Obviously, they are people who have experience running restaurants.

The main advantage of trading over many other types of businesses is its relatively low operating cost and other resource requirements. This makes trading highly efficient in terms of capital deployment. I will use the following example to illustrate the point.

Nowadays, to start trading all you need is opening a brokerage account that provides free software for online order placement. Of course you need a computer, internet access and initial trading capital. People living in the cities around the world are very likely already have their own computers and internet access. Trading capital can just be a very small amount if you are trading forex. This means the amount of money you need to commit into trading is close to 100% being used for the generation of profit. The overhead expenses are ignorable because you need to spend those money anyway.

For running a small business like a hot dog stand, the situation is very different. You need to purchase a hot dog stand cart that is properly equipped (i.e. meeting government standard). You also need to obtain a license in order to sell hot dogs in many parts of the world. Only after you invested into these items, that your remaining capital can be used for the purchase of inventories like hot dog sausages, buns and soft drinks to sell for profit. The cost of your inventory comparing to your selling prices is relatively low but it is relatively inefficient as only 10% to 20% of your capital is being used for the actual generation of profit.

To make my points clear – if you need $5000 to start a hot dog stand business and that $4000 is spent on the equipment, the remaining $1000 being your capital for inventory purchase and other ongoing expenses, it is no better than someone who has $1000 to start trading a small forex account. Both businesses carry similar level of risk while trading forex has a much higher profit potential and that selling hot dogs has a better chance of survival.

As an entrepreneur, we do not go into business to just make a living.

The Power of Scaling Up

It is not uncommon for good emini traders to make $200,000 to $500,000 annually based on $100,000 or less trading capital. In comparison, a successful local restaurant may generate that kind of money but we are talking about hiring 10 to 15 people with complicated logistic issues. It means the restaurant has to make $1,000,000 in sales before it can generate the kind of profit we see with a good trader having just a reasonably sized trading account.

And don’t forget the need to invest in equipment and renovation of the restaurant. It is likely many times more than $100,000 to furnish a restaurant into one that can attract clients. I would say that $300,000 is the likely minimum one need to invest into a new restaurant in not so expensive cities. Yet, with the $100,000 capital, one can trade effectively to generate profit matching that of a successful restaurant, less the headache of running a hectic business involving many staff, suppliers and customers.

Considering the entrepreneur who started out with a hot dog stand. Even if the business is doing very well and making good money, should the entrepreneur want to scale up to run a restaurant, he will have to come up with the capital for the equipment and renovation expenses first. Yet, for a good trader who managed to save up just $100,000 instead of $400,000, can effectively scale up the trading business with profit potential matching a successfully operated restaurant involving $400,000 or more initial investment.

Summary

Trading is a great way to make a living but I am not asking everyone to trade instead of running other businesses. Not everyone is suitable to trade full time for many good reasons. Just like running other businesses, it takes entrepreneurship and the development of expertise in specific financial markets to make a trader proficient in trading those markets. Some people are better off running their own businesses or developing a distinctive career in other fields. For these individuals, they can still learn to trade so that they can better manage their savings on the side.

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