May 5, 2008

The impact of bad decisions on your wealth creation

“You only have to do a very few things right in your life, so as long as you don’t do too many things wrong.” – Warren Buffet. What should be your motive as an investor? – To earn great return on your investments with minimum risk, right?

bad decisions

We generally take good amount of risk to get more return, and many times we get it 🙂 … It might happen that if we make good profit 2 times , we make 1 loss also because of the high risk we take. And we think its fair getting the losses, and you are right if you think so. We cant get profit always, if we take risk we have to accept losses.

But is it a good strategy?

Its questionable, lets explore on this topic today. Lets try to find answer of a question, what is better?

1. Taking high risk for high return at the cost of losses some times.
2. Avoid getting losses at the cost of just moderate return and not great return.

Case Study :

– Robert do not understand much about investments, but still invests in high risk high return instruments like shares and risky mutual funds. He invests Rs.1,00,000 for 5 yrs and gets returns of 50%, -35%, 30%, -20% and 45% for 5 yrs.

– Ajay does not take much risk and invests in something which gives him better returns than conventional FD’s or PPF, but has risk component much lower than Robert case. he earns return of 8%, 17%, -10%, 20%, 15%.

Who has more money at the end?

Robert : 1,00,000 * (1 + .5) * (1 – .35) * (1+ .3) * (1- .2) * (1 + .45) = Rs.1,47,030

Ajay : 1,00,000 * (1 + .08 ) * (1+ .17) * (1 – .10) * (1.20) * (1 + .15) = Rs.1,56,940

Observation : A fixed deposit will give similar kind of returns 1,00,000 * (1 + 8.5/100) ^ 5 = Rs.1,50,365

Why did this happen?

Getting 0% profit overall is better than getting X % loss after getting X% profit. if you get 40% profit and then 40% loss on your investment of 1,00,000, it will first become 1,40,000 after profit and then it will become 1,40,000 * (1 – .40) = 1,40,000 * .6 = 84,000, which is a loss of 16%.

So even if you get 40% profit, a loss of 28.57% is enough to wipe out that whole profit earned.

If Robert never got those losses and only profit, his final amount would be Rs.2,82,750. Just loss of 35% and 20% ate way most of it. On the other hand Ajay, who put more efforts on avoiding losses on the cost of getting less return way rewarded more at the end.

The return percentage required to cover the losses is more than then percentage loss.

Watch this video by Harsh Goela. In his talk, Harsh Goela talks about the stigma surrounding stock markets. He clarifies how it is different from gambling and how proper knowledge and avoiding reckless indulgence can yield profitable results.

Learning and Moral

What do we learn from this article and the examples above?

The important part of investments are not earning great returns but taking measures to avoid losses. Earning high returns must be secondary goal, the major goal must be to avoid losses at any cost though we have to compromise on moderate returns. Because one loss is enough to wipe out major portion of your profits and the hard work you take to earn great returns.

I would be happy to read your comments or disagreement on any topic. Please leave a comment.

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Chetan Ambi
Chetan Ambi
10 years ago

“You only have to do a very few things right in your life, so long as you don’t do too many things wrong.” – Warren Buffet… Nicely said.

Hema Kumar S
Hema Kumar S
13 years ago

Hi, Can u tell me which software u r using for interactive charts?

15 years ago

usually the equity are meant for long term (specially > 5 yrs)so for example if we take a scenario like 8 years with a returns like
-45.00/10.00/50.00/50.00/45.00/-30.00/50.00/15.00..compared to 10@ annum on a FD the returns on the former is more greater than the latter.Hence Over a long term u get an avg return of 18% per annum for the risk taken..Hence the effect of Loss on the overall return is clearly minimized.For a period of less than 5 years Equity is not the place to invest.

Note: Above figures are just an estimation.

u k banerjee
u k banerjee
Reply to  RajanT
13 years ago

This are only stray comments devoid of logic. It is ridiculous to suggest that equity investments are good for period > 5 years. This is not valid across the board but depends on the particular equity. The buzz word is a constant surveillance with the firm belief that by design, neither can an equity be purchased at its lowest rate nor it can be sold at its highest. An average person shall target an appreciation of 20% of investment for a decision to exit.
UK Banerjee