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In a number of my publications over recent months, I have, on a number of occasions, stressed on the importance for investors to be patient, be humble, take informed decisions, educate oneself, take an interest. The list of educational topics I have touched upon range from market nitty gritties (from a markets and economics perspective) but I have also touched upon the textbook stuff, about the importance of keeping informed, about the need for an investor to constantly update him/herself on market developments.
Taking informed decisions, both on the buy side (when entering into an investment) as well as on the sell side (when exiting from an investment to either keep cash or switch into another investment) is paramount in ensuring that the risk of an investor and the underlying investment are completely aligned. Being informed in such cases could take different forms, but to keep things simple, an investor ought to know which company s/he is investing in, the intricate dynamics of the market being invested in, the current investment climate; there are endless ways of how to keep informed.
One key concept which I stress to be of utmost importance is the accurate assessment of calculating returns on an investment. At face value, it may seem easy for an investor to calculate percentage returns, from the data of purchase till a specific date. But there are two key concepts which an investor ought to keep in mind:
(1) An investment is not worth the same, in currency terms, if it increases by the exact same percentage today that it would have decreased by yesterday. In simple terms, if the value of an investment in ABC plc is worth €1,000 today and declines by 10%, and increases by 10% tomorrow, the value of the investment in ABC plc is NOT worth €1,000 tomorrow.
On day 1, the price of ABC plc tumbles by 10% so the value of the investment drops by €100, and at the end of the trading session, the investment is worth €900.
On day 2, following a positive set of results, the price of ABC plc increases by 10%. 10% of €900 is €90 and hence the value of the investment at the end of the trading session on day 2 is worth €990, €10 short of its original value.
Following a 10% decline on day 1, the share price of ABC plc would have had to increase by 11.1% in order for it to fully reach its original value.
(2) The daily percentage changes on an investment cannot be added up (in percentage terms) and equate to the same percentage change in added up terms. In simple terms, if an investment declines by 10% daily for three successive trading sessions, it would not be a correct assessment to state that that investment declined by 30% (10% + 10% + 10%).
The value of an investment in XYZ plc on day 1 is €1,000. On day 1 it registers a 10% decline, and closes day 1 with a value of €900 (€10,000 less 10% of €1,000), on day 2 it registers an additional decline of 10% and closes day 2 with a value of €810 (€900 less 10% of €900), and on day 3 registers a decline of 10% once again, closing day 3 with a value of €729 (€810 less 10% of €810).
Say now that, during the course of the week, the shares of XYZ plc decline by 30% from its original value on day 1 of €1,000 – the value of the investment in XYZ plc is now (at the end of the week) worth €700 (€1,000 less 30% of €1,000)
It might appear obvious to some but not to others that percentage movements/returns CANNOT be summed up between different readings. It would be inaccurate and this is precisely why I am linking the importance of taking informed decisions to accurately calculating returns on investments. It is only by grasping the concept through simple worked examples such as the above that we can truly appreciate market movements, how they impact investment portfolio and how they (should) shape our daily investment decision making process.
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