Showing posts with label simple averaging. Show all posts
Showing posts with label simple averaging. Show all posts

Friday 14 October 2011

The difference between Simple Average Returns and Compound Returns


Below is an illustration of the difference between simple average returns and compound returns, as well as the impact of losses no matter when they occur. Each Manager (A through F) had a different investment approach and therefore, performed differently in each of the three years. The table represents the different returns year-after-year over a three-year period for six separate managers.

Client A
Client B
Client C
Client D
Client E
Client F
Year 1
10.0%
6.0%
16.0%
30.0%
45.0%
55.0%
Year 2
10.0%
10.0%
10.0%
-20.0%
-30.0%
-35.0%
Year 3
10.0%
14.0%
4.0%
20.0%
15.0%
10.0%
Simple Average
10.0%
10.0%
10.0%
10.0%
10.0%
10.0%
Compound Returns
10.00%
9.95%
9.89%
7.66%
5.29%
3.49%
Ending Value of
$1 Million Invested
$1,331,000
$1,329,240
$1,327,040
$1,248,000
$1,167,250
$1,108,250


In each case, the simple return over the three years is 10%, whereas the compounded return (the amount of gain you have realized) fluctuates between a high of 10% and a dismal 3.49%. Despite the larger returns in some years, the investment is more severely impacted by the loss. Interestingly, as the size of the loss increases, a greater percentage gain is required to restore the account back to breakeven. In short, it is important to understand that managers can brag about simple averages but you can only spend compound returns. Our goal is to execute investment strategies that capture the most of bull markets while preserving gains in bear markets to provide superior long-term compound returns.
*While our rule of thumb for investing is "don't lose money", investments have the potential for negative returns over both the short and long term. Our goal, however, is to limit the downside through security selection, asset allocation, diversification, and the use of active risk management, including the use of options and contra-funds.




Compound returns are the most precise and accurate reflection of your portfolio's bottom line and thus, they are of utmost concern for you.

Compound returns are a reference to the
cumulative impact of gains or losses on your portfolio, they are a reflection of your ability in your investing and they are indications of how much money is in your account. Simple returns, on the other hand, are the returns that occur each day, month or year and are only a snapshot look at an investment's performance without regard to its history. 


For example, if a portfolio is down 10% one year and up 10% the next, the simple return on this portfolio is 0% and the manager can report a "break-even" performance over these two years if he refers to his simple returns. However, when it comes to compound returns, which reflect the net effect to your account, the portfolio is actually down 1%. The loss in year one reduced the amount of capital invested for the following year and therefore, a higher performance was needed simply to return the investment to breakeven. It would take an 11% gain to make up for a 10% loss, regardless of the order of the gain/loss.

Saturday 13 June 2009

Dollar Cost Averaging vs Simple Averaging

There is a difference between simple averaging and dollar cost averaging.

Tan Teng Boo averaged down on a stock and profited. Let us look at what he did.

This was taken from this week's icap newsletter:
"A stock that the i Capital Global Fund invested in plunged around 85% during the 2007-2009 bear market. However, instead of selling as it dropped, we bought so much more of this stock that the cost price plunged around 80% too. By now, the i Capital Global Fund is sitting on a gain of 175% on this particular stock. The reason why ICGF bought so much more was because if it was attractive at higher prices, it is even more attractive at depressed prices since the business fundamentals of the company have not changed. "

What ICGF did. http://spreadsheets.google.com/pub?key=r_MxUHLmwJhsKRpR7JklS1Q&output=html

Simple Averaging

The first point to clear up is actually the difference between dollar cost averaging and simple averaging. What Teng Boo did above was not DCA but simple averaging.

Buffett does not believe in DCA. "It does not make sense investing in stocks when the prices are high." However, Buffett will employ simple averaging, often buying a good stock he likes in large amount when its price is down for no good reasons.

DCA

Those employing DCA should learn its limitations too. It is a way to diversify risk, and is definitely not a strategy to optimise your returns. Various studies quoted that returns from lump sum investing beats those from DCA, 60% of the time.

There are risks too from DCA. If the stock price tanked due to deterioration in its fundamentals, using DCA equates to throwing good money after a lousy company and should not be employed. Also, remember that the same amount used for DCA into a stock is an opportunity cost, to investing in another stock.


The Only Reason to Simple Average or Dollar Cost Average

I did pick up a very important point. It was good to see this advice in print. For those who are investing in good high quality stocks, averaging down can be employed in ONE particular situation, when its price tanked for no good reasons. However, there is still the need to ensure that your good high quality stock's fundamentals have not deteriorated.



To summarise:

There is only one reason that justifies simple averaging or dollar cost averaging - when its price tanked for no good reasons. However, there is still the need to ensure that your good high quality stock's fundamentals have not deteriorated.

If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.

An investor put it: "The company and its business have not changed. The only change is its share price got beaten down."