In the world of finance, percentage return is probably the performance common currency. In other words, if you gain ten percent from an equity investment, 10% from dividends, 10% from a derivative, 10% on 100 thousand and 10% on one thousand; 10% is 10%.
Buy and hold investors and those who’s grasping of mathematical concepts peaks at checking the odds for Saturday football, may not be stirred by what follows. However, those that enjoy following markets, especially those that trade equities frequently, will find the following concepts invaluable.
10% up is not equivalent to 10% down
Imagine placing your savings in the equity market on Monday. On Tuesday the market falls ten percent. On Wednesday the market climbs ten percent. Thus on Thursday your portfolio should be back to its original value right?
Wrong. Suppose on Monday you had invested €1,000. Following the ten percent drop on Tuesday the portfolio is now valued at €900. By the end of Wednesday the market climbs back ten percent. But ten percent of €900 is not €100 but €90. On Thursday your portfolio value is €990. Thus if you lose ten percent you need to gain 11 percent if you want to return back to square one.
This concept is called decay and is especially important for investors that relay on leverage. Suppose that instead of a straight equity investment your investment is a 3x leveraged ETF. A ten percent index decline translates in a thirty percent decline in the investment; your €1,000 investment is now €700. The ten percent recovery pushes the portfolio back only to €910.
3% dividend when the price of the stock if €1 is not equivalent to 3% dividend when the price is €10
This concept is especially important for the long-term investor. Suppose that you bought an Allianz SE shares in January 2013 when the price was at around €102 per share. That year the company paid a dividend of €4.50 per share or, in this case, 4.41%. Suppose Allianz SE decide to maintain the same dividend ratio today when the share price was trading at €173. In this case the dividend would be €7.60 per share.
But your initial investment was at €102 per share, as above. Therefore, the €7.60 per share that you receive now would mean a 7.5% dividend on your initial investment. Allianz actually paid €7.60 per share on the 8th of May and are expected to pay €7.90 per share next year. Imagine what this means for those investors who bought Allianz at €100 during the current low-interest environment.
10% on one thousand is not the same as 10% on two thousand
This is so obvious that is it often completely ignored but on this concept hinges the idea of compounding. Suppose that equity markets return 10% yearly on average. The return on a €1,000 investment in the first year is obviously 10 percent. By the end of the fifth year equity markets still return ten percent but by the end of the fourth year the investment is now worth €1,464 so in the fifth year a ten percent gain will translate into €146 not €100. This principle is probably the most important concept for investors.
Disclaimer: This article was issued by Antoine Briffa, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.