FX Trading is one of the easiest occupations in the world to enter. Within five minutes of hearing about Currency Trading, a would-be trader can turn on their computer, logon to a broker’s website, open an account, deposit as little as $500 and in no time take their first trade!
Try doing that in Law or IT or Medicine, or any profession for that matter. We wouldn’t dream of starting out as a plumber or operating on a patient with such little knowledge or background, yet we will rush into the largest financial market in the world, trading against hedge funds, central banks and financial institutions.
In my next three Trading Tutors newsletter articles, I’m going to discuss three key areas of preparation that are essential for success in this industry.
This article, the first of the three, is about getting your personal finances in order prior to stepping into the trading ring.
The second article will discuss Business Plans and Trading Plans, two very separate but equally important documents for all traders.
The third article will deal with Mental Preparation, which is no less important than the first two.
I was very fortunate to come into the business of trading with an accounting background. I took it for granted that everyone knew about Balance Sheets and how to balance a budget. After many years of teaching, training and coaching students, I have come to realise that my accounting background was a big advantage and that not everyone understands these things.
If you do not have your personal finances under control then you will struggle with trading. If your personal finances are a mess – perhaps you are in severe debt, or spending more than you earn, or don’t know how much money you have etc – then you WILL carry these traits across into your trading. Sloppy personal finance habits do not make for good traders!
There are three things that I believe everyone needs to have under control when it comes to personal finance, regardless of whether or not you are trading and investing. These are the Balance Sheet, the Profit & Loss Statement and the Budget. I am going to focus on these mainly from a trader’s perspective.
The Balance Sheet
This is a statement that tells you your net financial equity or worth. In other words, if you cashed in all of your financial investments and items of value and paid off all of your debts, this is the amount that you would have left.
If you have ever applied for a loan or a credit card (or a trading account) you would be familiar with this exercise. It involves three steps:
Step 1 is to list all of your financial assets, such as cash, term deposits, shares, rental properties, gold, currency positions etc. and add up the total value.
Step 2 is to list all of your liabilities, such as home loans, credit card debts, overdrafts etc. and to add up the total value.
Step 3 is to subtract your liabilities from your assets to give your equity, or net worth. Hopefully this figure is positive and grows each time you do the exercise. I do this every quarter, i.e. four times per year.
Why is a Balance Sheet important for a trader?
A Balance Sheet gives you clarity and focus. It tells you where you are financially, right now. It also helps you to focus on your goals – where are you trying to get to? It also helps you to decide how much money you are going to put into this new business of trading and where that money is going to come from.
As a general rule, the money you deposit into your trading account should not be borrowed and in the event that you trade recklessly and lose the lot, it should not leave your balance sheet with negative equity. Ever!
So where is the trading account money going to come from? In Chapter 12 of the Smarter Starter Pack, David Bowden suggests using cash or selling an asset to fund your trading account.
Preparing a personal Balance Sheet is a simple but powerful exercise.
The Profit & Loss Statement
A good business will know and measure all of its revenues and expenses and we should treat our personal finances no differently. A Profit & Loss Statement, (also called a Revenue Statement), will tell you how much money is coming in and how much money is going out. Like the Balance Sheet, we want to see a positive figure here!
A simple Profit & Loss Statement should list your sources of income (employment income, interest on deposits, share dividends etc.) as well as all of your expenses (living expenses and investment expenses, such as interest on margin loans or rental property loans). You may even break the expenses down into Tax Deductible or Non-Tax Deductible expenses, but that is a conversation to have with your accountant.
Your total income should be more than your total expenses for the year. If your expenses are larger than your income, you are running a deficit. This is a problem that trading is unlikely to fix. This needs to be remedied before you start trading. Many traders enter trading with the intention of creating an additional source of income (profit) but end up creating an additional source of loss by not preparing properly.
Why is a Profit & Loss Statement important for a trader?
Because it tells you how good (or otherwise) you are at handling money. If you are spending more than you earn you may experience self control or discipline problems in trading.
Many people with poor discipline enter trading hoping that it will bring them instant success and become the answer to all their money troubles. In reality, if they do not already have some skill and discipline in handling money, they will struggle to go anywhere but backwards in trading.
A Profit & Loss Statement also helps put trading profits and losses in perspective. If you are sitting on a profit that is the equivalent of your yearly salary, you might want to lock it in! Likewise, if you are sitting on a loss that is more than you make in a month or quarter, you may want to reconsider your position sizing and risk control.
Like a Balance Sheet, the Profit & Loss Statement provides a useful a point of focus and perspective.
The Budget (or Cashflow) Statement
A Budget is an estimate of the expenses you are expecting to incur in a given period. For most people this will be on a monthly, quarterly, or yearly basis.
I’ve seen people come up with all sorts of funny ways to estimate their expenses for the year ahead but to my mind, there is only one way to get this right – you need to go back and analyse your actual expenses so that you know exactly what you have spent.
I use a spreadsheet to go through my expenses every month and I document every transaction that appears on my bank statement, plus all my cash expenses. I then place them in categories such as Motor Vehicle Expenses, Donations, Utilities, Business Expenses, etc.
At the end of the financial year, I can look back on my spread sheet and see how much I have spent and on what. This gives me a good idea (within 10% usually) of what I will spend next year and where I can cut back, if need be.
Why is a budget important for a trader?
Part of it comes down to discipline – if you can balance a budget, you will likely have the discipline to follow a trading plan. I wouldn’t hire anyone to trade for me who couldn’t balance their personal budget, whatever their excuse!
A balanced budget also gives you peace-of-mind that your expenses are covered and that there is no rush to make big money. This can prevent you from taking unnecessary (aka stupid) risks in the market and damaging your trading account.
The ultimate goal is to increase the equity on your Balance Sheet and produce enough income to fund the lifestyle of your choice, now and in retirement.
The Balance Sheet, Profit & Loss Statement and Budget are the foundations of any financial success and this is especially so for traders. Having these in order should stop you from risking money you can’t afford or shouldn’t be trading. If you are frightened about what will happen to the money in your trading account, there’s a good chance that at least one of the three items listed above is out of order.
‘Frightened’ money in trading is as good as already lost. If you are worried that you won’t succeed or won’t have enough for your next holiday or even to put food on the table, then you are not likely to make sound trading decisions.
In Part 3 of this series I will discuss the mental preparation required to be a trader. Trading will test your emotions more than most businesses so any mental edge you can gain is a real bonus. Having your personal finances organised is one such mental edge.
If your personal finances are in order and you can honestly say you are on top of these three items, congratulations! You are ready to move to the second step in the Preparation for FX Trading, which I will cover next week.
If you are struggling with one or more of these items, there are plenty of great resources out there to help you and I urge you to get these important items in order before moving on to the next step.
For the purposes of setting a budget, ASIC provides a handy free resource at www.moneysmart.gov.au. I recommend everyone have a look at this (including some governments!)
For general personal finances, I like Robert Kiyosaki’s first two books, “Rich Dad, Poor Dad” and “Cashflow Quadrant.”
Stay tuned for Business Plans and Trading Plans in next week’s Trading Tutors newsletter.