hi all
i dont have any investment in funds so i’m not sure how it works but I keep reading that an index like sp500 gives about 6-8% return yearly, and compounding will grow your capital even more.
Does this mean that at the end of each year you will have the balance adjusted automatically according to that year’s performance? I mean, if I enter at let say 3500pts and hold for 5 years, during which is had extremes highs, but then on the 5th year it goes back down to 3000pts and I exit, would I still have made profit or will it be like a perfect break even since 3000-3000 = 0 increase? cause if the balance will breakeven wouldn’t it means that there’s no compounding at all?
So like you I had also just read up on your hypothetical scenario and have formed my own conclusion:
So the S&P 500 is sitting at 3,943.34 points right now, if you invested in it you can be confident that it will continue to go up but remember you can’t be 100% sure every year will go up. It is possible to make rough calculations to figure out the value in the next (t) years if you also know what interest you will be payed an how often.
Like you said:
So you can also figure that out that out with something called Compound Annual Growth Rate (CAGR) - This is assuming that the profits were reinvested at the end of each year of the investment’s lifespan.
This is the first time I have looked into this topic as well so I hope what I have given you at least gives you some idea.
This is the first time I have looked into this topic as well so I hope what I have given you at least gives you some idea.
no worries about that, actually many thanks for your help.
I’m not that good with math formulas so i’ll have to google more about it, but what i’m not quite understanding is this
This is assuming that the profits were reinvested at the end of each year of the investment’s lifespan.
how can one re-invest the profits if the trade/investment is still open? if you do not close the trade, it will remain as unrealized profit so there will be no compounding effect on it as there was no additional capital re-invested.
Hi Lee-Gi,
I will try to explain this without complicated maths. If the market started at 3,000 and went to 4,000, it would be a 33% increase (the increase of 1,000 divided by what it was at the start 3,000 is 1/3 or 33%) If the second year it went up to 5,000, that is a 25% increase (increase of 1,000 / 4,000 = 25%). If the third year it went up to 6,000, that is a 20% increase (increase of 1,000 / 5,000 = 20%. Now in the fourth year, it goes down to 3,000. That is a loss, not a profit. And it is a 50% loss (-3,000 / 6,000 = -50%).
So if you had held the SP500 for four years and sold it at the end of four years, you would break even. But during the meantime, it had made +33%, +35%, +20% then -50% to get to that break even.
I hope this explains that there is compounding, but if the profit is negative (a loss) it still compounds with the positives, and in this example, the end result is no profit and no loss (break even)
But you didn’t take into consideration the fact that you will be payed interest on the profits - even if the S&P dropped back to breakeven there is still a small amount (or large) of capital left over so I think there is still profit to be had.
Thank you for the straightforward answer it is clearer than mine.
Hi Kian,
If you invest in shares that make up the S&P listing, you will receive dividends. I am not aware that an investment (or trading position) on the S&P index comes with “interest on the profits”. Another member may wish to comment on this. I have no direct experience in either investing or trading in S&P index or any other market index.
@Mondeoman
thanks a lot for your time to explain
but if you sum up the % you have 33+35+20-50 = 38% profit
so if you break even there’s no compounding in it no? or am i missing something?
so what happens to the +38% difference?
@KianMcGrath thanks for the link am reading it right now
Hi Lee_Gi,
Percentages don’t just add up like that, and it is important to realize this since it impacts your perception of risk. Let’s say that I have £100 invested, and I make 25% profit. I have £125. Now let’s say I make a 25% loss, and I now have £75. How much profit do I need to make on £75 to get back to break even and have my £100 to be back at square one? 25%? NO. If I make 25% on £75, I only have £75 x 1.25 = £93.75. I have to make 33% back on the £75 just to get back to break even. So a 25% loss is worse than a 25% profit. Going back to the first line - where I made 25% profit to get to £125, I only need to lose 20% of my £125 to get back to square 1 position of £100, whereas I had to make 25% profit on £100 to get to £125. That is why the profit and losses cannot be added up. Sorry to be the bearer of this bad news, but from a percentage point of view, it is far easier to lose money (% wise) than it is to gain money. That’s just the way it is.
thanks for the indepth explenation. yea kinda sucks it works tha way, especially when it’s the same both ways! (i would have though if you add up and then deduct it should go in your favour but you will still lose!) but now I understand it thanks once again
Always a pleasure. One of the reasons I spend some time in replying forum posts is to make sure of two things. The first is to make sure I understand the question and I think I know the right answer. The second is to ensure that I can explain that answer in the shortest possible number of words (which I am not very good at). The longer in the tooth I get, the more I try to create explanations that make sense to anyone regardless of their level of expertise in a subject. I try to use real world examples that people can relate to, and it is satisfying when somebody gives feedback (positive or negative). These are the building blocks on which confident trading is being built, so don’t hesitate to continue asking questions.
I am not very good at maths. So, I avoid making any kind of calculations to avoid making wrong moves. But thankfully, there are online calculators available with most brokers that make the task easier and faster for traders like me.
There is a lot of math that you will have to do to find the answer you have been looking for. But I personally don’t think that you should be wasting your time on such things. There is so much more that you can do and for calculations, there are online calculators that work great.
