February 10, 2009
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This introductory article is intended for the educated layman. It was written as part of a continuing series of essays on a variety of investment topics.
I was reading an instruction book for backpackers a few years ago. The author emphasized the importance of carrying a light load, which makes sense, but I was brought up short by his discussion of how to choose a magnetic compass. He referred to one model that had a number of features and weighed one ounce. Then he described another, simpler model that weighed only 0.8 ounces. “This is just 0.2 ounce lighter,” he wrote, “but that’s still a 20-percent weight saving.”
This is completely backwards! He should have written, “That may be a saving of 20 percent in weight, but it’s a difference of only 0.2 ounces.” A shaggy backpacker might lighten his load the same amount by just getting a haircut.
A consideration of why the original statement is wrong provides a lesson in how to think about investment returns.
How to Think about Investing
How to Think about investment Risk
A backpacker carries weight, not percentages on his back. An investment produces money or increased value, not percentages. We use percentages to express relative values. An investment that has a return of 20% is one fifth larger than its original value. If the original portfolio was worth $1,000,000, then most people would agree that the increase of 20%, or $200,000, was real money. In contrast, if that original portfolio was worth $1, the added 20 cents wouldn’t make even the poorest citizen of the United States feel much better off.
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