Stock Market Math
eBook - ePub

Stock Market Math

Michael C. Thomsett

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eBook - ePub

Stock Market Math

Michael C. Thomsett

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About This Book

Stock Market Math shows you how to calculate return, leverage, risk, fundamental and technical analysis problems, price, volume, momentum and moving averages, including over 125 formulas and Excel programs for each, enabling readers to simply plug formulas into a spread sheet.

This book is the definitive reference for all investors and traders. It introduces the many formulas and legends every investor needs, and explains their application through examples and narrative discussions providing the Excel spreadsheet programs for each. Readers can find instant answers to every calculation required to pick the best trades for your portfolio, quantify risk, evaluate leverage, and utilize the best technical indicators.

Michael C. Thomsett is a market expert, author, speaker and coach. His many books include Mathematics of Options, Real Estate Investor's Pocket Calculator, and A Technical Approach to Trend Analysis. In Stock Market Math, the author advances the science of risk management and stock evaluation with more than 50 endnotes, 50 figures and tables, and a practical but thoughtful exploration of how investors and traders may best quantify their portfolio decisions.

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De Gruyter

Chapter 1
Rates of Return on Investment:
What Goes In, What Comes Out

Even the most seemingly easy calculation can become 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 results.
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.
A business model of return on capital may present problems, however. Accuracy is in question when the calculation is based on a fixed value, such as capital, versus current value of the same investment:
The book value of capital might not be a good measure of the capital invested in existing investments, since it reflects the historical cost of these assets and accounting decisions on depreciation. 1
The same question may be applied to capital invested in shares of stock. Since capital is a fixed value at a particular time (purchase of shares), but current valuation may be significantly different, the potential impact makes this calculation one that has to be considered with some qualification, perhaps even discounting its value in favor of return on cash invested.

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 of the investment and the reliability of your own decision-making capabilities, you will need to figure out how well the investment has 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 easy to fall into the trap of believing 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. 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.
  3. The specific method of calculation is not understood. It is difficult to determine whether an investment is a success of 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 of these variables have to be considered with consistent comparisons between them or they will not be valid.
  4. 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.
  5. The varying degrees of risk are not taken into account. Risk is not only as aspect of opportunity; it is really the reverse effect of it as well. Opportunity for profit and risk of loss are two sides of the same coin. This relationship between the two attributes is shown in Figure 1.1.
Figure 1.1: Relationship between opportunity for profit and risk of loss.
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 assessed based on potential for both profit and loss.
6.Comparisons fail to include compound rates of return versus simple return. In calculating return, there are numerous methods in use and are explained later in this chapter. However, in estimating future returns, it is important to know whether you will earn a simple return or a compound rate of return. For example, if you are buying shares of a mutual fund, will you take your dividends and other distributions in cash? If so, your annual returns will be simple. But if you instruct the fund to reinvest your earnings, your investment account balance will increase each time you earn; the result is a compound rate of return and over many years it will be much higher. So without deciding in advance how your mutual fund or stock earnings are going to be treated, it is not possible to set profit goals for yourself.
The important determination of an investment’s success has two components. First is the decision as to how much profit you expect (or how much loss you will accept). Second is deciding how to compute the outcome.
Setting goals involves identifying the profit you hope to earn and, if you do not plan to hold your investments indefinitely, the point at which you will sell. It also involves identifying when you will sell if the investment falls in value. At what point will you bail out and take a small loss to avoid a larger loss later on?
The second part— deciding how to compute profits and losses—is equally important because you need a consistent, reliable, and accurate method to assess your investing success and make valid comparisons between different investments.

The Basic Equation: Return on Cash Invested

Calculating return is perceived to be rather simple; and it is, as long as the amount of money placed into the investment is the entire amount invested. In some cases, though, you deposit only a portion of the investment’s total value, deferring payment of the remainder. Anyone who has ever purchased a home knows that the down payment is only a small portion of the property’s total value; the remainder is financed and paid over many years.
The same thing happens with investments. For example, if you use a margin account you are allowed to buy stock and pay for only one-half of the current market value. The balance is held in margin and interest is charged. The concept here is that when stock’s price moves upward, margin investors make twice the profit (less interest) because they can afford to own twice as much stock. It’s a great concept, unless your investments lose value or take too long to become profitable.
Another example involves the use of options, which is explained in greater detail later in this chapter. As one form of leverage, you can control shares of stock with the use of options for a fraction of their market value. So, calculating return will be more complicated when option...

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