Difficult times are times for great learning. COVID-19 is one of them. The other side of COVID-19 has the potential to differentiate the men from the boys while teaching us all lessons on the way.
One of the most important and key lesson in investing, is the rate of return. And the fact that the rate of return is linked to the base that you are at.
Quiet often, the potential rate of loss or the rate of gain (rate of return) is not understood clearly which doesn’t help in planning for investments and timing the entry into a stock or portfolio. And more often than not, this is explained in the context of loss (fear psychosis) rather the potential for gain (possibilities).
“The way you see the glass – half empty or half full – has the potential to determine what you do with what you see”
I say this because in investing literature, losses are connected with break even points. You will hear sayings such as:
If you lose 10%, you will need 11% to break even.
Base Determines The Rate of Return
What the above essentially means is that if you have invested 100$ on a stock and it falls down to 90$ (loss of 9$ out of 100$) you will need to generate 11% (gain back 9$ out of 90$ which is the new base) to break even(so that your losses are recovered).
Extending this hypothesis leads to the following table with various scenarios where stock has fallen by 10%, 20%, 30%, 40% and 50%.
Assumes stock has been invested at $100 (price point A) which is the base.
It’s that much harder to claw back your losses.
|Initial Stock Price (A) – Base||Stock Fell to (B)||Percentage Loss due to fall (C = (A-B)/A)) in %||Amount stock needs to rise to break even (D = (A – B))||Stock has to rise by how much % from B to break even (E = D/B in %)|
What you will notice is that, if there is a market or a stock or a portfolio falls, to claw back your losses, the rate of return that you need to achieve is much higher. This is often used as a hypothesis to highlight the point that you need to manage your risk to avoid the downside. This is because any losses you incur it is so much harder to claw back your loses.
If you go back to the earlier part of the article, you will realise that we had talked about the base determining the rate of return. And if we look closely, the table above assumes the base as $100 i.e your starting point is an investment of $100 which is your existing portfolio. We come down from the base and then again, regain the losses back to breakeven – no loss, no gain. Its like saying empty your bottle and then try filling it again – of course it’s harder to fill it again. So, the concept of breakeven is 0% loss/gain which in a situation where stock falls by 10%, you need to regain 11% to come back to 0% loss/gain.
This is a useful hypothesis which signifies the important of mitigating risks and knowing what it takes once you have incurred the losses.
Now, for a moment, let’s re-think what happened in the current market nosedive during the COVID crisis. Think of 22nd March. That scenario is ripe for thinking the “glass is half full” way. Let’s re-look at the table to see if we can re-define our base. What if we didn’t start with a portfolio or stock of $100. But essentially, we had zero dollars invested when the stock was at $100? Market came down. Although the times were uncertain, we could safely assume that the market on the other side of COVID, would rise back to previous levels or higher in stocks which were conducive to the post covid environment. It is this scenario where understanding the table and capitalising on gains becomes important. Most of us don’t realise this basic maths and the potential for high gains. Let’s assume the stock was at $100 (A) and there was no initial investment made. Investment was made only when the price was down at price point B.
If a share comes down and you believe it will go back up, you should look at E (3rd column in table below)
|Stock Price after Fall (B) – Base||If invested at lower price B and market went back to $100, profit D||Gain %E = D/B in %)|
As an investor, if you started making investments at a lower level imagine the level of profit you would made when the market went back up. Savvy investors make the most of this when the pitch is down and tide is low. They go for the kill, knowing well that the situation is temporary. Simply saying if a stock has fallen by 50% due to circumstances outside its control and its temporary as it was in the case of COVID, and assuming stock would be unscathed after, if investment was made when the stock was down 50%, your return would be 100% once the market recovers back to its original value.
If a stock has fallen by 40%; you make an investment at this level when the stock has fallen thus far; stock then goes back to its original value, you stand to gain 67% on return.
I am not sure, if I made it easy for you to understand. But just think what would have happened if you have filled your bottle when it was empty; wouldn’t it be easier than you emptying it and then trying to fill it again. Think about, what you could have gained if you had invested during the covid crisis.
And next time, someone talks about how much you need to breakeven if you lose, think how much you can make if you invest when the chips are down. Re-thinking from this point of view, has the potential to change the game completely.