Investment 101 : Difference between the Drop and the Bounce
During an investment update recently, an investment manager remarked that the markets since the start of the year have been really stable with very little volatility.
There was silence. Then the punchline followed.
“Volatile markets means that the markets go up and down. Since the start of the year, the markets have only been down, down and down. This is also a form of stability.”
At times when the indices are a sea of red, humor is one of the few comforts we can still allow ourselves. However, for those who have seen their portfolios shrink, it is certainly no laughing matter.
Amongst the current correction, there is a very valuable lesson I’ve learnt some years ago when it comes to investing – The difference between “The Drop” and “The Bounce. Not understanding this difference can be costly and as a matter of fact, it has been for many who have invested during the technology boom and are still holding on to the investments waiting for it to recover.
Difference between “The Drop” and “The Bounce”
Let me explain this and I hope this can be a useful reminder (if you have heard it before) or a piece of valuable knowledge if this is new to you.
Suppose you made an investment and unfortunately, the investment is down by 50%. So for example, you bought a unit trust at $1 and the price went down to $0.50. This is known as “The Drop”.
Almost all investments over time will suffer from “The Drop” because this is how a normal market behaves. After “The Drop”, a normal market will also recover and we call that “The Bounce”.
Using the same example just now on an investment which had come down by 50%, what is the price of the unit trust if it recovers or “Bounces” up by 50%?
The question seems straightforward. If an investment drops 50% and subsequently bounces back up by 50%, I should breakeven. The price of the unit trust should thus be $1.
However, if you work the numbers, you will realize that while percentage wise there is no difference, the value of the investment has. If the investment at $0.50 grows by 50%, the price of the unit trust will only be $0.75.
This loss of 25% is the difference between “The Drop” and “The Bounce”.
Avoid the “Drop” and avoid playing Catch Up
Very often when it comes to investing, investors focus on the returns. Fund factsheets often indicate the returns in percentage terms over time periods. This focus on chasing percentage returns may blindside you to being caught in a big “Drop” which will almost guarantee that you have very little chance of breaking even, let alone growing your wealth.
As much as investment is about growth, make sure there is sufficient balance to manage the downside “Drop” risks to avoid spending a long time trying to play catchup.
Start Early, Drive Slowly and Arrive Safely!
Article by Lee Meng, FChFP
(NOTE: Use our free calculator to help you calculate your investment returns, especially if you have invested in Unit Trusts and Investment-linked Insurance Policies. Get yours here)