Even if maths is not your strength, understanding a few simple concepts will help. One of these financial concepts is percentage decreases and subsequent increases.
A 50% decline in value means a 100% gain before you are back to the original position. People make the mistake of thinking if something has gone down by 50% then it just needs to go back up 50% and all will be good. Well it will be better, however, not back to the starting position. Numbers make this more clear, rather than talking about numerators and denominators.
Opening balance
50% decrease
Closing balance
$1 000
$500
$500
Now if you think a 50% balance will get to back to square one you are wrong. It will only get you half way there. That is because you balance is now $500. From now on the original $1000 is meaningless for these calculations.
Opening balance
50% increase
Closing balance
$500
$250
$750
As you can see, you’re only back to 75% of the original $1000 balance. You need a 100% increase to get back to your original balance.
Opening balance
100% increase
Closing balance
$500
$500
$1 000
To repeat, if something drops by 50% then it will need to increase by 100% to get back to the original position. This is why when trading things like stocks, it is vital to recognise and take the losses early. Before they get too large.
Human nature being what it is, we have trouble taking losses.
You might be thinking, yes 50% drop is unusual so it’s not that bad. Well here’s a less extreme example with a 20% decrease.
Opening balance
20% decrease
Closing balance
$1 000
$200
$800
As you can see below, with a 20% decrease it takes a 25% increase to get back to the original balance.
Opening balance
25% increase
Closing balance
$800
$200
$1 000
This shows that the effect is exponential as the percentages increase. The difference between 20% and 25% is not nearly as much as 50% and 100%.
This affects everything from houses to stocks to cryptocurrencies to mutual funds to collectibles. Stocks listed on a public exchange is the obvious example because you know the market value at a point in time. Knowing about this concept helps you accept a loss early, rather than hanging on too long. Human nature being what it is, we have trouble taking losses. We have to accept we made a mistake.
The strange thing is, taking the loss clears it from your mind, You don’t have to see or think about it when reviewing your reports and you will forget the amount very quickly. On occasion I’ve had to choose between a couple of stocks and the result is a loss on the one I chose. I get annoyed. I take the loss and a day or two later I’ve forgotten.
- How many times have you hung on too long only to lose even more?
- How often have you made a 100% return?