7IM Short Thoughts: Problematic percentages
The cruel law of percentages.
In finance we talk in percentages all the time but as humans, we don’t intuitively work in this way. And as a result, we tend to oversimplify.
In the latest Short Thoughts, Chris Justham explains why this simplification can be wrong using recent Meta as an example.
So you might have seen Meta in the news last week. That's the artist formerly known as Facebook. And the reason it was in the news is because it rose by 20% in a day and everyone got really excited as a result. Now, I'm not here to talk about the merits or otherwise investing in technology or whether or not Mark Zuckerberg is looking to take over the world with his Matrix-like business.
No. I'm here to talk about the other part of the headline, which is the percentage. Now, whenever we use percentages, our brains get really confused, which isn't really ideal actually in the investment world, because we use them all the time. But here's an example: so if your portfolio was to fall from 100% to 99%, broadly speaking, you need 1% to get back to where you were.
That's okay, we can all grasp that. But if your portfolio falls by 50%, you don't need 50% to get back to a 100%. You need 100%. And this is where it gets a bit scary because the numbers get even bigger. If your portfolio fell by 75%, you’ll need to quadruple your money from that point just to get back to an even keel.
So if you ever wondered why we obsess and we worry so much about this sort of stuff in risk management, this is why. Because that is a big old hole to climb out of, if you end up falling that far.
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