Math and investing

If you want to be a good investor in stocks, you’d do well to master a little math. Here are a few concepts to grasp, some of which may surprise you.

For starters, imagine that Acme Explosives Co. (ticker: KBOOM), a $40 stock, rises in value by $40, reaching $80. That’s sometimes referred to as a “two-bagger” — a 100% gain. It’s a little counterintuitive, but a doubling is a gain of 100%, not 200%; tripling is 200%, quadrupling is 300%, and so on.

Now imagine that KBOOM keeps growing and reaches $400 per share. Then if it gains another $40, going from $400 to $440 (from a “10-bagger” to an “11-bagger”), that represents just a 10% gain. So from $40 to $80 was a 100% gain, but from $400 to $440 is just a 10% gain. Read these paragraphs a few times if you need to; these are unfamiliar concepts for many of us.

Meanwhile, you might assume that after a 50% drop in a stock’s price, you’d need a 50% gain to get back to even. Nope. Imagine that shares of Meteorite Insurance (ticker: HEDSUP) dropped by 50%, from $60 to $30. To get back to $60, the stock will need to double, gaining 100%. If the stock drops 75%, from $100 to $25, it will need to quadruple, gaining 300%, in order to get back to $100. Even a more modest 20% drop in value will require a 25% gain to recover. As the drop gets bigger, the required return for a recovery gets much bigger.

Of course, never focus too much on the size of the gain you need to get back to even — because you might end up waiting too long for a poor performer to improve, and it might never gain that loss back, anyway. A stock may have fallen 60% or risen 200%, but what really matters is how likely it is to keep growing at a good clip. If you’re pretty sure it has a rosy future, hang on. If not, sell and move the money into a more promising investment.