What is Investing?

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Alright, I should give credit to the following statement to Benjamin Graham who practically invented the definition of investing on the Wallstreet. According to him "Investing is an activity that gives positive returns on the capital with out any loss of capital". Anything other that is called Speculation.

I'm sure now you must be thinking what the hell is that? So, if you are investing in an Idea say a Green technology, Alternative energy, New drug etc.. think before you invest. What is the chance of your success in that endeavor? Do you know the probability of success? There are 1000 ideas out there sucking cash out of investors and only 1 in 100 materializes. So if you go with 1 in 100 odds of making money then I don't think it is wise investing. You would rather visit LasVegas once.

Once we agree on the definition of investing then it becomes even more interesting. Now how do you actually invest. Isn't that Holy grail everybody is after.

Charlie Munger said"tell me where I'm going to die, and I will not go there". So true, If I know where to invest for a fixed 20% +ve return why wouldn't I go there and put my money! Beware of Madoffs of the world. That's exactly why when somebody says I will give you a fixed return upwards of 15% or for that matter any return more than 30 day TBill, they are basically Ponzi selling you something.

So, you would ask what then is Investing?

Investing with a business sense is what we call expecting a series of cash flows on any busienss you own. That is what is studied so meticulously under Value investing. It is all about figuring out what a business is worth and how much cash flow to expect from that business and what price to pay for that at what time.

Back to Basics: Calculating the growth rate of your portfolio

Back to Basics: Arithmetic Mean and Geometric Mean for your portfolio:

When you look at a Mutual Fund or a Money manager's returns, did you ever wonder on how to come up with the actual return on that portfolio for a given time series? Ok, here is the answer for you. To Calculate the growth rate of your portfolio you just calculate the geometric mean of all the annual returns. For e.g.

If a Fund A has the following returns from 1996-2002

1996 25%
1997 42%
1998 -65%
1999 2%
2000 12%
2001 -30%
2002 10%

1/6√(1+.25)(1+.42)(1-.65)(1+.02)(1+.12)(1-.3)(1+.1) - 1 = -.08 = -8%

So, in this caase the fund lost 8% every year for the seven year period or it grew at the rate of negative 8 percent. I'm sure you would not be happy to invest in this fund!
Coming to Arithmetic Mean, usually you say the average return for a fixed period such as an year, a half year, a quarter etc. Typically we consider the returns for an year averaged for that whole period and we come up with an annual return.

Finally to conclude: You have to use Geometric Mean to calculate the growth rate. You refer to an average return as an Arithmetic Mean only for a specific interval to get a better approximation of returns for that interval.

That's all for now. We will talk about other statistical measurements next time.