Editors Note: Comparing different investments with different dollar amounts and time periods is arithmetically more challenging than it first appears. When I do my side-by-side comparisons (such as IBM, Decker, or Boston Beer), I always do the same dollar amount and the same time period. Simon does a really good job of explaining how to do this if they are not the same dollar and time period.

Guest Post by 

Ralph and Jackie are both keen investors in the stock market. In this article I’m going to explain how they can use two different methods of calculating a rate of return in order to compare the performance of their investments.

Ralph buys $1000 worth of stock in AlphaCorp. He holds it for exactly 2 years and then sells it for $1200. Jackie buys $3000 worth of stock in BetaCorp. She holds her stock for 1 year, and sells it for $3300. Just to keep the example simple, we’ll assume that neither Ralph nor Jackie receive any dividend payments from their stock.

Ralph and Jackie now want to compare their investments. They know that there are two main methods they could use: the Arithmetic Return and the Logarithmic Return (often shortened to Log Return).

Ralph’s total profit is $200, and Jackie’s is $300. So this tells them that Jackie has made more money overall. But she also invested more. Investing more usually means she took a greater risk (if the stock went down she would lose more money). To take this into account, they want to know the profit as a percentage of the amount invested. This is exactly what the Arithmetic Return gives them.

For Ralph’s investment in AlphaCorp the arithmetic return is 20%. For Jackie’s investment in BetaCorp the arithmetic return is 10%. So based on the arithmetic return, it looks like Ralph has made the better investment, as his gained 20% in value compared to 10% for Jackie’s investment.

But notice that Jackie sold her stock after 1 year, while Ralph held his for 2 years. The arithmetic return doesn’t include the duration of the investment, so these values cannot really be compared meaningfully. So now Ralph and Jackie compare their investments using the Logarithmic Return, which does take this into account to give an annual rate of return for each investment.

For Ralph’s investment in AlphaCorp the log return is 9.12%. For Jackie’s investment in BetaCorp the log return is 9.53%. Both of these are annual rates, so they can be directly compared.

So who made the better investment?

Based on the logarithmic return, Jackie’s investment was slightly better than Ralph’s. However, there is a slight caveat to mention, which is that Jackie sold her investment after 1 year, while Ralph held his for 2 years. If she really wants to do better than Ralph over 2 years, she will need to find another investment to make for the second year that does at least as well as Ralph’s 9.12%.

Both the Arithmetic Return and the Log Return are useful ways to compare the return on investments. The log return is normally the best choice for investments that were held for different lengths of time because it gives you an annual rate that you can compare between investments.

Article Source: http://EzineArticles.com/?expert=Simon_B_Veal and http://EzineArticles.com/7167133

 

Many readers have reached out to me to ask about how to run a balanced portfolio. This article is designed to help you with general guidelines for developing such portfolio. A balanced portfolio should be 20-40% in index funds and 60-80% in individual stocks spread out among many industries. This allows you to have exposure to the general market, the international market, and the growth of truly well-run companies. The proportion of money between index funds and individual companies should be dictated by your age and how soon you will need the money to pay for life’s expenses.

The first thing to do is invest 20 to 40% of your portfolio in index funds. Divide these index funds into at least four categories:

  • international funds
  • bonds funds
  • small-cap or mid-cap funds
  • large-cap funds

I suggest that you balance your fund investments equally every year. This means that you would have 5% of your portfolio in each fund category. You may have to annually add money from the individual stock 80% of your portfolio to maintain at least 20% index fund exposure.

It really doesn’t matter which company manages the index fund you choose. There is some variation in international funds since they can track many different markets so you may need to study a bit for that component. There is little true variation in bonds funds so just find one that tracks the Barclays Capital Aggregate Bond Index. For the stock index funds, they should track one of the S&P indexes or one of the Russell indexes.

If you are over 65 then you may want to start dropping down to 60% of your portfolio being in individual stocks and 40% index funds. You definitely want to consider this if you are over 75 years of age. However, if you are under 65 then you probably should have a portfolio of stocks that is approximately 80% of your portfolio. At 65 you may think you need to be more cautious but there is a high probability that a 65 year-old person is going to live to be 90. If you have reached the glorious age of 75 then you are even more likely to live to 90.  With 25-45 more years of spending to do, you really need your money to continue to grow even if you are retired. As you approach 80 or 90 years, you may want to have a more even mix of stocks, bonds, and money-market cash. To understand this better, check out my whitepaper, Retire In Luxury.

Divide 80% of your portfolio into equal allotments that are larger than $5,000 per allotment. You should have at least 10 allotments in a balanced portfolio. You could have 20 or 30 allotments depending on the size of your portfolio. If you do not have $50,000 to divide 10 ways then divide your existing portfolio into $5,000 increments. You will find that you are much more efficient and profitable if you invest $5,000 or more using GOPM. If you have fewer than 10 allotments, be very diligent about getting a good mix of industries so that you are not overly hurt by any one trend.

Regardless of the number of allotments that you choose, you need to choose twice that number in stocks that you are tracking.  So if you have 10 allotments, you should track 20 stocks. This allows you to always have a stock that is rising to invest your money. Invariably, some of your tracked stocks will be going sideways or down but by tracking double the number you need, you are likely to have 10 that have upward momentum.

You should plan on investing in 10 to 30 companies at a time using the tools that I show in The Confident Investor. Grow your investment in any individual stock until you have doubled your money using GOPM (Grow on Other People’s Money).

When you have doubled your money in half of your companies, you may want to consider changing your allocation size to a larger allocation. This will allow you to continue to grow your investment in those great companies.

It is also possible to stop investing in any given company at half of an allotment or twice allotment depending on how you feel about that company. You should also factor the number of companies in the same industry you already having a portfolio. For instance, if you have 2 companies in nearly every industry except you only have one mining company, feel free to allow that mining company to grow to a double allotment. Similarly, if you have 3 software companies in your portfolio then you may want to limit one or all of them to a half allotment so that your portfolio is not overweight in that category.

Let me show you an example of a 50-year-old man (we will call him Bob) that has been able to save $150,000 in his IRA account.

  • $7,500 in an international index fund
  • $7,500 in a bond fund
  • $7,500 in a small-cap  or a mid-cap fund
  • $7,500 in a large-cap fund
  • $120,000 divided into 10 allotments of $12,000 each.  This means that Bob will purchase up to $12,000 in any stock on the 20 possibilities.

For the 20 stocks, Bob chose the following from the Confident Investor Watch List:

Apple Inc. Technology – Personal
Akamai Technologies Technology – Internet
Ansys, Inc. Technology – Enterprise Software
Atlas Pipeline Energy
Caterpillar, Inc. Manufacturing – Machinery
Chipotle Mexican Retail – Restaurant
Cirrus Logic Technology – Semiconductor
Deckers Outdoor Footwear
Ebay Inc. Retail – Web
Extra Space Storage Real Estate
Goldcorp Inc. Mining – Gold
Google Inc. Advertising – Web
Hms Holdings Corp Healthcare – Services
Helmerich & Payne Energy
Merck & Co., Inc. Pharmaceutical
Net Servicos de Comunicacao Telecommunications – International
Priceline.com Inc. Retail – Web
Boston Beer Alcohol Beverages
Washington Banking Finance
Yum! Brands, Inc. Retail – Restaurant

Bob will invest in these companies as indicated by the technical indicators described in my book, The Confident Investor.  You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in ebook formats for Nook, Kindle, and iPad.

I recently read an article on CNN Money advising investors to invest in consumer product goods (CPG) companies. The logic was that CPG companies, as a group, have several features that should be appealing to investors:

  • Predictability – these companies can predict how much of a product can be sold in the short-term so they control pricing and inventory well.
  • Dependability – these companies are not going to see massive drops in revenue since consumer purchase their products regardless of the economic climate.
  • Pricing power – due to their brand loyalty, these companies can put forward regular price increases with little negative market reaction.
  • Global reach – while most of CPG companies get the bulk of their revenue in the western world, many have made significant investments in emerging markets.

The problem with the article is that the cited companies were fair at best, and some were poor. Instead of the CPG companies in the article, I suggest that you look at good companies such as Coach [stckqut]coh[/stckqut], Decker [stckqut]deck[/stckqut], Boston Beer [stckqut]sam[/stckqut], or Fossil [stckqut]fosl[/stckqut] (all of these companies are currently on my Watch List). If you want to own one or two of the companies in the article, P&G [stckqut]pg[/stckqut] (the stock symbol is not PR as cited in the article) or Unilever [stckqut]ul[/stckqut] are decent candidates – both companies are very well run.

Settling for companies that are familiar to you and you see on the grocery shelves may not be a good investment strategy.  I suggest that you focus your portfolio on companies that have more upside potential but are still very well run.