Imagine a stock that falls fifty percent one day and rises fifty percent the next day. Seems like you’d have broken even, right? Wrong. This is the beauty of mathematics, and it occurs in the stock market all the time. While this shouldn’t be a significant problem for your investments, it can often be misleading and confusing when researching and analyzing stocks.
Let’s use the example of a recently volatile stock known as E-Trade Financial (ETFC). The stock price experienced a large sell off and dropped to $8.59 per share, a 58.7% drop. The next day a rally occurred in the stock market and E-Trade’s stock soared up 40.9%. This left the stock at $5.00 at the end of the day. This is a key example of how the percentage mathematics used in stock prices can easily be misleading to casual investors.
Now let’s break down this problem in simpler terms. Suppose you bought XYZ stock at $10 per share. It remains around $10 per share and suddenly it falls 80% one day due to a sell off and ends the day at a meager $2 per share. The next day, the aggregate stock market sentiment is the stock was oversold, so a rally occurs and the stock soars up 50%. If you were a long term investor during all this madness, you’d still be down significantly. A 50% rally in a $2 per share stock will only result in a $3 stock price. Which means despite the face value of 80%-50%=30%, you are actually down 70% on your investment of XYZ stock because the price per share ultimately went from $10 to $3.
Investing in the stock market is confusing enough already to the amateur investor in today’s conditions; So always keep this in mind when you research and analyze stocks as this is an easy mathetmatic occurrence to forget about or overlook.
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Hi,
I am new to the world of investment and stocks/finance. I would like to know if somebody could post some basic articles about the mechanism of changing stock prices. I would like to learn more about how and why prices go up and down.
Thanks,
V
Sure thing Varun, I’ll write an article about why prices fluctuate soon.
This issue applies to annual returns as well. You need to be careful if annual returns over a multiple year period is calculated using the arithmetic mean or geometric mean. The arithmetic mean is the total of all year’s total returns divided by the number of years. The true compounded annual return should be calculated by looking at the starting and ending value divided by the number years. In both cases, be sure all dividends and distributions are included in the total return and assume they are reinvested. This means you just can’t look at the start and ending prices to determine returns, as many funds have a significant income component.
what do all the numbers in the newspapers mean as they pretain to the stock market? like above it says DOW 8,237.58 -223.73 (-2.63%) what does that mean?
8237.58 is where the DOW is currently at. The -223.73 means it was down that many points at the close of the day, and the final number (-2.63%) is the percentage the DOW was down. Percentages are a more accurate way of indicating the activity of a market, so they always include that figure.