Things you should know before you invest

November 2, 2009 in Finance

The WSJ's top story this morning was one titled "The Cruel Math of Big Losses" - an article written as if it were an eye-opening expose into a little-known piece of financial wisdom rather than a blatantly obvious restatement of basic math: when you lose X%, it takes a gain of more than X% to get back to even.

Nonetheless, I've seen the mistake time and time again - and it is exactly what leads people to chase levered ETFs despite their downward bias. It is especially amusing that many of the comments on the article fall in two camps: either the article is a waste of time because percentages don't matter, only dollar amounts, or it's a waste of time because its a boilerplate nascent recovery article.

To the first point, percentages are all that matter. Yes, if you lose $50 you need to make back $50. But what if you started with $100? What if you started with $1,000 - or $51? The risk (both future and encountered) on those three portfolios is very different and must be considered as such. It remains beyond me why we insist on reporting stock changes in terms of dollars or points. Is it relevant to me that the S&P is up 12.8 and the Dow is up 124.2? Of course not! - but saying that both of them are up 1.26% is actually useful information. At least with individual stocks you could do some mental arithmetic, taking the numbers of shares you hold times the dollar change - but that doesn't work with the indices. Let's beware this "dollar price" fallacy: if you don't have a spreadsheet (and even if you do!) dollar prices should not be your primary concern.

To the second point, a wise investor would keep in mind that this math works both ways (neither of them helpful): gains can quickly evaporate when the market drops a relatively smaller amount.

This article serves a useful purpose: it reminds us of the basic temperament of the market. It forces us to confront the difficult nature of the investing exercise. But it should never come as a surprise.

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