What Goes In, What Comes Out
Even the most seemingly easy calculation can get quite involved.
For example, what is your "return"? If you invest money in a stock or mutual fund, you need to be able to figure out and compare the outcome. But as the following explanation demonstrates, there are many different versions of "return," and you need to be sure that when comparing two different outcomes, you are making a like-kind study. Otherwise, you can be deceived into drawing an inaccurate conclusion. And accuracy is one of your goals in going to the trouble of drawing conclusions in the first place.
The "return" you earn on your investments can be calculated and expressed in many different ways. This is why comparisons are difficult. If you read the promotional literature from mutual funds and other investments, the return provided in the brochure could be one of many different outcomes.
This is why you need to be able to make distinctions between return on investment and return on capital. Your investment return is supposed to be calculated based on the amount of cash you put into a program, fund, or stock. Most investors use "return on investment'' in some form to calculate and compare. The return on capital is usually different and is used by corporations to judge operations. To further complicate matters, capital is not the same as capitalization, so corporate return calculations can be difficult to compare. Return on capital normally means capital stock. Capitalization is the total funding of an organization, including stock and long-term debt.
■ Judging the Outcome—What Did You Expect?
All investment calculations are done in order to monitor and judge standards. You enter an investment with a basic assumption, an expectation about the return you will be able to earn.
In order to judge the quality or the investment and the reliability of your own decision-making capabilities, you will need to figure out how well the investment performed. In so doing, you need to be aware of some popular mistakes investors make, including the following primary points:
1. The purchase price is the assumed "starting point." It is an easy trap to believe that the point of entry to any investment is the price-based starting point. Thus, the assumption is that price must move upward from that point. No consideration is given to the realistic point of view that price at any given moment is part of a continuum of ever-evolving upward and downward price point movements. As a starting point, price does not always move upward. In other words, profitability is not the only possible outcome; the rate of return may also be negative.
2. There is no possibility of a loss of value. Investors also tend to overlook the possibility that they can lose money in an investment. But there is an unavoidable relationship between opportunity and risk. The greater the opportunity for profit, the higher the risk; this is inescapable. So picking the "best" investment is a matter of identifying how much risk you are willing and able to take.
3. A bail-out and/or profit goal is not specifically set. Too often, an investment is made with little or no idea about the individual's expectations. Do you plan to double your money? Triple it? Or would you settle for a 15% return in one year? Equally important is the question of possible loss. How much of your investment capital will you lose before you cut your losses and close it out? If you don't set goals and identify the point at which you will close the investment, then you cannot know what to expect.
4. The specific method of calculation is not understood. It is difficult to determine whether an investment is a success or a failure unless you also know how the return calculation is made. This includes making clear distinctions between different types of returns, the effect of taxes, and how the formula works. All these variables have to be made consistent between comparisons or they will not be valid.
5. The time factor is not considered. You need to take into account the reality that not all investments produce a return in the same amount of time. The longer the time required (thus, the longer your capital is tied up), the less effective the return. So the time element is crucial to the comparison of one investment to another.
6. The varying degrees of risk are not taken into account. Risk is not only an aspect of opportunity; it is really the reverse effect of it as well. Opportunity for profit and risk of loss are like two sides of the same coin. This relationship between the two attributes is shown in Figure 1.1.
Even so, some investors focus only on the "heads" side and invest with the profitability potential in mind but have made no plans for the contingency of loss. How much could you lose? How much can you afford? What criteria do you use to judge risk? For example, investors who base their decisions on fundamental analysis look for revenue and earnings trends and compute working capital and capitalization ratios. Investors who prefer to trust in technical signals check price volatility and look at charts. Whatever method you use, a decision should be judged based on potential for both profit and loss.
7. Comparisons fail to include compound rates of return versus simple return. In calculating return, there are numerous meth-
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