Can You Pass This Math Test?

I love tests. Always have.

The way I see it, they’re a challenge — an opportunity to prove what you know — and also find out what you don’t know.

I recently told my 11-year-old daughter the same thing when she was complaining about school.

And then she turned around and did something really awesome – she made me a math test as a present for my recent birthday.

She searched the Internet and found some of the hardest SAT questions… put them into a little Google slideshow. And then gave me a set of rules for taking the thing (maximum 45 minutes, prizes depending on the number I got right, etc.).

Cool and creative, right?

And now I’m giving you the same type of gift today: a series of investment-related math questions.

It’s not as terrible as it sounds, I promise.

Question #1:

At one point in my career, I was running a real-money $100,000 portfolio for my dad and sharing the results with readers.

We made more than $54,000 over the course of several years of the publication and then decided to call it a wrap. But at one point, a reader wrote in and asked how to mirror the portfolio – which consisted of a bunch of different stock positions – with just $32,000 in starting capital.

Do you know how to do it?

Well, here’s the answer:

If you divide $32,000 by $100,000, you’ll get 32%.

That means you should then multiply every single position in the portfolio by .32 to arrive at the correct allocation for any given position.

And you’re so close to 33%, or 1/3, that you could also use that friendlier divisor and come close enough, too.

Okay, here’s another one for you…

Question #2:

You’re at a cocktail party and someone tells you they just made $10,000 on a single trade.

Are you impressed or not?

The answer, at least to me, is that you can’t answer.

See, one of my biggest pet peeves is hearing investors talk about gains and losses in dollar terms rather than percentages.

We don’t know how much the person initially invested to get that $10,000 profit!

If it was $1,000 you should be darn impressed. But if it took a million, then it’s probably time to go refill your drink.

Or what about someone who says such-and-such stock was “up ten points” yesterday?

Giving you this information isn’t helpful at all unless you know the starting point.

This is why I always prefer percentages. Percentages don’t lie.

If someone says they got a return of 45%, the only other thing we need to know is the timeframe; the amount of money originally invested is largely irrelevant.

It’s the same thing if someone tells you the Dow rose 2% — you don’t even have to know where it opened that morning to immediately grasp what happened.

Of course, a lot of people misunderstand the difference between percentages and percentage points…

Question #3:

Consider the following two sentences:

Sentence A: “Stock XYZ beat the S&P 500 by 10 percent last year.”

Sentence B: “Stock XYZ beat the S&P 500 by 10 percentage points last year.”

Are they expressing the same idea?

Well, let’s assume the market was up 10% last year.

That means in Sentence A, stock XYZ was up 11% for the year.

Here’s the math behind the answer: 11 minus 10 equals 1, and 1 divided by 10 equals .10, or 10%.

Sentence B, however, says stock XYZ rose 10 percentage points.

In other words, it rose 10% above and beyond the market’s 10% gain.

So in Sentence B, stock XYZ was up 20% for the year… which is quite a difference in meaning from Sentence A!

Okay, final question for today…

Question #4:

Does a $1 stock carry more profit potential than a $1,000 stock?

Plenty of people think so. They tell me they like “cheap” stocks because they get more bang for their buck.

There’s no doubt on a day-to-day basis, you will likely see much sharper moves from the typical smaller stock.

It’s also true that some tiny companies go on to become huge success stories creating huge windfalls for their early investors.

But how many small firms go belly up for every one that skyrockets?

Or how many small shares crash just as quickly as they soared?

Meanwhile, larger stocks – whether you’re talking about the size of the company or the share price – can also double, triple or quadruple in value.

Just look at Apple Computer. It’s up about 780% over the last decade and it was hardly a small, unknown, low-priced stock in 2009!

To me, it’s far better to fixate on a stock’s value rather than its price. A truly “cheap” stock is one where the underlying business is worth more than what share price suggests.

After all, it doesn’t matter if you buy 1000 shares of a $1 stock or one share of a $1,000 stock.

You’re making the same overall investment in dollar terms… and a 10% rise in either gives your portfolio the exact same result.

To a richer life,

Nilus Mattive

— Nilus Mattive
Editor, The Rich Life Roadmap

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