Friday, March 2, 2012


In investing there are 3 fundamental questions:

1. What to buy?
2. When to sell?
3. How much did I gain (or lose)?

Let's try to answer each one.

What to buy?
For the first question, of course, you want to buy something that increases in value. For every asset, its price will vary according to a number of factors, the most basic ones being supply and demand. But trying to predict prices can be quite difficult, and people may have different oppinions or theories, most of them can be quite unprovable.
But any prediction can always be confirmed, by simply waiting for the result. Trying to prove the theory behind the prediction though can be tough.
For any given asset, will its price go up or down? And why? That is the most fundamental question for every investor.

When to sell?
For the second question, one possible strategy is to define upper and lower limits. You sell every time the price goes above or below a certain limit. You cut your losses every time the price goes too low, and you realize your profits when the price goes too high. Too high a price is always a dangerous sign because no asset will have its price going up forever, a high price always indicates an inevitable fall, so it is better to realize your profits before the fall. On the other hand the price can go down to zero, so a low price may not be a sign for a future rise. If you have no reason to believe the price will go up, then it is better to cut your losses and sell.

What limits should I use?
One book I read suggests 10% for the lower bound. You sell if the price falls more than 10% of its original price.
The upper limit could be set as 25%. Unhappily these numbers seem to be arbitrary, you can choose whatever numbers you like.
The only detail is that the upper limit should be higher than the lower limit. It is possible to calculate the probabilities of winning, considering each investment as a bet.
If the minimum is 10% and the maximum is 30%, you can make money if you are right more than 25% of the time. You can afford to lose 3 out of 4 bets and still win.

How much did I gain (or lose)?
For the third question, how to calculate profits, I think there are 2 ways to calculate it. You can calculate the yield for every investment, from the time you buy to the time you sell. And you can also calculate the monthly profit, by deducting monthly expenses from monthy revenues.
As an investor, you need to know how much money you are making (or losing) and which investments are being more profitable.
Calculating yield is easier. Yield is the percentage your investment has increased in a certain period of time. If your investment has increased 40% in 2 years, your yield is 20% per year.
But percentages can be tricky. You can sell a pencil for 100% profit or a house for 1% profit, and make much more money with the house. So a higher percentage doesn't necessarily mean "more profitable".

The yield can also be calculated before selling. You can calculate how much the yield would be if you sold the asset today. But this yield is hypothetical, it is not telling you how much money you are making. You have no obligations to sell just because the price is low. You don't lose any money as long as you don't sell. If you have reason to believe the price will go up, that the low price is temporary, you can just wait.

You can also calculate the monthly profits. For that you have to write the balance sheet and profit/loss statement.
In accounting, when you buy an investment, say a mutual fund, you are just exchanging one asset (cash) for another. You are neither making nor losing money. You make money when you receive dividends and when you sell the investment. The difference in price will be your profit (or loss) plus the dividends.
In accounting the total profit from an investment can only be calculated after you liquidate (sell) the asset. You can, just like yields, calculate a hypothetical profit, supposing you sell the asset today, but this number cannot be officially written in the financial statements.

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