May 9, 2012

Test your Financial IQ (#1): Calculating Stock Returns


Photo by Trucknroll

Learning to managing money intelligently and improving our financial lives also involves feeling comfortable while dealing with numbers. For those who invest in stocks, try this test to judge your Financial IQ:

Questions:

Q-1: A stock has fallen 30% this year after rising 80% last year. What is the net return? Is it 50%?

Q-2: If a stock you purchased is down, say 80%, how much it should rise to bring it back to your acquisition cost i.e., how much percent returns are required to bring it to the same level? Is it 80% , 100% or 200%?

Q-3: You own a stock which has continuously risen
during last 25 trading sessions? Is the chance of its price falling in next trading session high? What do you think? Will you be more willing to sell the stock?

Q-4: If a stock gives you a monthly return of 50 per cent, what is the expected annual return?

Q-5: Is the following statement correct: Markets are cheaper when the Sensex is at 15,000 as compared to a Sensex value of say, 18,000 or 20,000?



Answers:

A1: Not at all, the net return is just 26%...surprised…let me clarify you this way…Suppose the initial price of stock was Rs 100, after a rise of 80% last year the stock price at the end of last year became 180. Now again during this year, it has fallen by 30%, so in absolute terms the stock has fallen by Rs. 54 and not Rs 30 because the base changed from 100 to 180.

A2: The answer is 400%. This is due to base effect. 100% rise = 50% fall; If 100 becomes 200 the return is hundred per cent, but when 200 becomes 100, it is minus fifty per cent (-50%). Therefore, to recover from a 50% loss, 100% gain is required and to break even after a 80% loss, 400% gain is needed. In other words, if the investment rises by 100% and then falls by 50%, you get zero returns. Put differently, a ten per cent loss followed by a ten percent gain or vice versa equals one per cent loss. Similarly a 50% loss followed by a 50% gain or vice versa equals 25% loss. It follows from the above that there is no limit to upside but downside can never exceed 100%.

A3: The probability of fall remains 50 percent despite previous continuous rise. Markets don’t have a memory. In case of random events, the probability of occurrence / non-occurrence of an event is independent of previous event...that’s why it is foolish to buy a stock just because it has fallen continuously during last few trading sessions or conversely, sell a stock just because it has risen continuously during last many trading sessions.

A4: Most of the time, returns calculated for a period shorter than one year are not annualized. It is in fact misleading to annualize return of less than one year in case of volatile asset classes such as equity because of the associated volatility. For example let’s say the ABC stock you purchased one month back is now doubled; annualizing the returns would mean that we expect the stock to continue doubling every month. However, in case of debt, it is acceptable to quote a return of less than a year as an annual return but that also only simple annualized returns.

A5 : For this see the post: Are you an Investor or a Gambler?



Also See:

1. Money Teaser #7: Stock Investing

2. PMS: Is it Portfolio Management or Mismanagement

3. 5 Mistakes to Avoid while Investing in Mutual Funds

5 comments:

  1. AnonymousMay 09, 2012

    I think the answer to Q2 is 400 % .
    Rs.100 after 80% loss becomes Rs20 . you need to gain Rs80 ie 400% of Rs20 to get back to Rs 100

    ReplyDelete
    Replies
    1. Oops! i got it wrong...thanks for the correction.

      Delete
  2. Excellent article written to know general qustions which mos of them think this is simple..Sometimes Simple makes to think a lot. Like this in this article I am able to answer only Q1 and Q3..

    ReplyDelete
  3. Nice article sir..It seems that i have to do something to improve my financial IQ.

    ReplyDelete
  4. Thnx for questions but these are very easy and also the number of questions are pretty less. Looking for more brain storming exercise by add questions on taxation on share trading or something like this.

    ReplyDelete

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