Sunday, August 22

The stock market and math

Not long ago, I had a meeting with a financial advisor and he shared something very interesting with me. Yeah, I know… What’s that got to do with tech, computer boy? As I’ve already reminded the both of you who read this blog, The Gray Geek is about me. And sometimes, I think about stuff other than technology. Not often, I grant you, but sometimes.

Anyway, the stock market. (My financial advisor friend did use a computer to show me this, by the way, so there!) Let’s say you have a dollar, to make the math easy. You invest that dollar and in year one, your investment gains 100 percent. How much do you have now? Two dollars, right?

Now year two. In year two, the value of your investment declines 50 percent. Now how much do you have? You’re back to your original one dollar. So, what is the rate of return on your investment over the past two years?

Zero? No. In fact, it’s 25 percent. Which sounds like you ought to be holding at least $1.25, but you’re not. You don’t have jack.

And that’s why you need to know the stock market’s dirty little secret. A smaller loss wipes out a bigger gain in dollars, but not in percentage. So the percentages look great, but long term investors are losing money. There’s an Oppenheimer mutual fund that I’ve been putting money in to for a long time now, years and years. Sometimes it’s been way up and sometimes it’s been down a bit, and recently I looked at the fund comparing what it’s worth to what I’ve actually paid in.

I’ve lost money. If I close it today and withdraw every dollar it’s worth, I will have paid more money than I have.

And the economists wonder why the small investor is getting out of the market and turning to bonds? They marvel over the fact that small investors don’t want to jump back in and catch the market at a low point, to profit on the ride back up? Really?

Here, I’ll help them out. Mister Economist, please take note. We can’t always figure out all your damn formulas and how those tricky percentages work, but we can count our money.


Anonymous said...

That's true (and deceptive). To calculate your geometric rate of return:

By using the formulas for calculating the average annual rate of return, we get a percentage that measures gains accurately over only a short period. Whereas, the geometric or compound rate of return is a better yardstick to measure your investment over the long run. The arithmetic mean or average return should be used to calculate return on investment only in the short-term.
Average annual return (arithmetic mean) = (Rate of Return for Year 1 + Rate of Return for Year 2) / 2 = (100% + (-50%)) / 2 = 25% (Arithmetic return = 25%)
Compound return (geometric mean) = (capital / return) ^ (1 / n) - 1 where n = number of years. The formula is (100 / 100) ^ .5 - 1 = 0%. (Geometric return = 0%)


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Unknown said...

Stock market investments can be highly beneficial but if market is not in good state then it can be hard to make money and this is why you need thoughtful analysis from experts before making any investment. Even I talked about some options with an expert and he suggested going with swp in mutual fund to get feel of things.

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