- New research from the Journal of Consumer Research reveals that semantics can trip people up when it comes to understanding percent change.
- High-percentage drops in your investments require an even large gain to break even.
- Experts note that you can drive higher returns over the long term if your portfolio loses less than the market when stock prices slide.
If you can't remember the last time you calculated the percentage difference between one value and another, think about the last time you were in the supermarket. This food brand contains 150% more protein than the leading competitor, the packaging tells you. That cleaning agent leaves 50% fewer germs on your kitchen counter.
If figuring out how much those percentages actually represent feels like a headache to you, you're not alone. New research published in the Journal of Consumer Research reveals that people tend to confuse relative size (150% "of" something) and percent change (150% more). Researchers found the confusion caused more than half of their subjects to underestimate percent changes by more than 100%.
"People tend to be really bad at understanding percentages," Milica Mormann, co-author of the paper and an assistant professor at Southern Methodist University's Cox School of Business, recently told the Wall Street Journal.
And it doesn't only come into play when you're figuring out how many more sheets of paper towels you're getting in a given roll. Changes in the value of market indexes and indeed the investments in your portfolio are typically expressed as a percent change. And knowing how the calculation works is essential to understanding how investments behave and how your portfolio grows over time, experts say.
If you're listening to the news in your car you may hear a market update that expresses market movement in terms of points. Something like: "In market news, the Dow fell 309 points today, and the Nasdaq shed 110."
Unless you're really tuned in to markets, that news can feel less than useful. Ask someone to name how many points the Dow is at, and chances are they won't know the correct answer of "about 30,900" off the top of their head. (The Nasdaq is at about 11,300 these days, by the way.)
Video by David Fang
Instead of using points, many financial media outlets tend to describe movements in indexes the same way you'd see gains or losses in the investments in your portfolio — as a percentage. To find percentage change, you subtract your starting value from the final value, divide by the initial value, and then multiply by 100.
So if the Dow started the day at 30,900 and closed at 30,591, you'd subtract to get -309, divide by 30,900 to get 0.01, and finally multiply by 100 to arrive at a 1% decline.
For investors, knowing the calculation is crucial to understanding how stock prices move. If, for example, you own an investment that declines by 1% yesterday, and climbs 1% today, you may think that you have broken even. But if you run the numbers, you'll see that's not the case.
If the total value of your investment is $100 and it declines by 1%, it's now worth $99. Add 1% from there, and you're up $99.99. That may not seem like a big deal at first blush, but the bigger the numbers, the more stark the disparity becomes.
Say you invest $100 in a stock that declines by 50%. Now it's worth $50. To get back to breakeven, your investment now needs to double in value — a gain of 100%.
Video by Helen Zhao
Large downdrafts can have an outsize impact on your portfolio because they require your investments to deliver extra-high performance on the upside to climb out of the hole. That's why investing experts recommend maintaining a diverse portfolio with a variety of different assets. Doing this can help mitigate the volatility of the market, and help your performance in the long run.
To illustrate this, investment research firm Seagall Bryant & Hamill analyzed the performance of the broad-market Russell 3000 index over the 20 years that ended in September 2020. Over that period, analysts found that a theoretical investment that performed 90% as well as the index when it was going up, but sank only 75% as much when stocks were falling, handily outperformed the index.
There is no guarantee that past performance will recur or result in a positive outcome. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions. No level of diversification or asset allocation can ensure profits or guarantee against losses.
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