Numbers That Matter, All of Them

By Brad Thomason, CPA

 

Grant got a ticket from the US Fish and Wildlife Service.  This was back when we were in college, and we’d stopped off to make a dive at Crystal River, probably on a road trip down to the Keys.  Near the spring that we were diving in was an area which had been put off limits in order to keep boaters, swimmers and divers away from mating manatees.  Essentially, while underwater, Grant swam right under the rope without realizing it, his bubbles breaking the surface were easily spotted by an agent going by in a boat, and upon resurfacing he was handed the citation.

There was a photocopy of it on the bulletin board back at the dive shop for awhile.  Grant wrote on it, “Navigation is composed of TWO elements, direction AND distance.  Ignoring one of those cost me some coin…”

In investing there are a couple of elements that we as investors ought to be paying attention to, as well.  One is the entry and exit price.  But the other is the time interval in between.  All of these numbers matter, because two investments which have the exact same gain or loss may not have the same return.

Let me explain.

Consider the case of a stock that’s selling at $40 at the beginning of the year, drops to $20 by summer, and recovers to $40 by the end of the year.  Its detailed price table looks like this:

 

January 1                             $40

April 1                                   $30

July 1                                     $20

Oct 1                                      $30

Dec 31                                   $40

 

Let’s consider the case of two investors.  Mr. A buys on April 1.  Mr. B buys on Oct 1.  Both sell on Dec 31.  For that year both will have a short-term realized gain of $10 ($40 out – $30 in).  Same amount of money, same tax treatment.  But Mr. B will have the higher return.  Why?  Because he did it in fewer days.  When we annualize the return, the result is 3 times what Mr. A’s return is.

Now in practice, the annualized return is only valid if he actually found something else to do with the money during the period of time he didn’t own the stock, something that had the same return profile.  But even if it’s not exactly the same, as long as he earned something, anything, during the six months that Mr. A was watching his $30 stock drop to $20 and then recover, Mr. B still wins.  Mr. A had what was essentially dead capital for half the year: pulling the trigger early got him no additional benefit as compared to what Mr. B got (since both got $10).

In portfolio math, a higher return at points along the way means the average return over the life of the effort is higher.  Higher average means more money.  In other words, this matters because those long-term results are the sum and product of what happens over shorter periods with the individual pieces.  Making $10 in three months is better than making it in nine, because you can use the extra six months to make additional money from something else.

If we want to get all theoretical and start talking about the risk element, there good news there too.  Mr. B had his capital exposed to a company-ending scandal for fewer days than Mr. A.  Mr. B also waited for the trend to reverse and confirm an upswing before investing; whereas Mr. A fought the trend, bought it before it hit bottom, and got to live through a bunch of days of uncertainty as a result.  Both mean that Mr. B’s results, on a risk-adjusted basis, were better still.

But even if we don’t get into any of that, one outcome was still clearly better than the other.

What’s the lesson?  The number of days it takes to harvest a win impacts the long-term results significantly, maybe just as much as the win itself.  Grant knew the restricted area was over there; he just didn’t pay attention to how far he swam.  You know you need to buy low and sell high.  But in your eagerness to buy low, don’t inadvertently set yourself up to have to wait an extra interval to be able to get the future gain.  If you do, you’ll knock yourself out of other opportunities along the way.  Missing them can make a big difference in the end.