1 of the biggest mistakes investors make is => when they compare the wrong return. There is a difference between
1) Simple Return
2) Compounding Return sometimes refers to Capital Annual Growth Rate (CAGR) or Internal Rate of Return (IRR).
Let’s play a game. Which is a better deal?
1) Option 1 – Placing RM 100,000 and getting back RM 130,000 in 2 years
2) Option 2 – Placing RM 100,000 and getting back RM 300,000 after 10 years
2 common mistakes investors make
1) Not comparing Apple to Apple
2) Not understanding the context properly
Let’s start with the first one.
Let me explain. If you do the math, option 1 will look like this
Looks like a great deal! 15% return on investment within 2 years. Wait, or is it a 14.02% return? 1 is Return on Investment (ROI) and the other is Compounding Return (CR). Notice the numbers are different.
In layman’s terms, ROI is what we normally refer to as a simple calculation
You take the Profit divided by the capital. Then divided by the number of years
For CR, it will always show a lower percentage. The main reason is, it takes into account the compounding effect, unlike the ROI straight-line calculation. The funny thing is that you still make RM 30,000 although both numbers show differently. For option 2, it looks equally good as well. You make RM 200,000 over 10 years
ROI = 20% and the CR is 11.61%. Again different numbers, but same profit of RM 200,000. Start to get confused? So if you put them side by side, it is a tough choice to make, isn’t it?
If you compare ROI, you will choose Opt 2
If you compare CR, you will choose Opt 1
The biggest problem happens when investors start to compare
a) ROI vs Compounding Return instead of
b) ROI vs ROI / CR vs CR
For eg 15% (ROI) vs 11.61% (CR) which is better? Or 20% (ROI) vs 14.02% (CR) which is better?
Never do this!
So instead of asking “Which investment gives a better return?” Always ask “Is this ROI or is this compounding return?” first. Then only compare.
So which 1 will you choose? Opt 1 or Opt 2? Share with me in the comments below and I will share with you the answer
P.S Next week I will share with you the 2nd common mistake investors make
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DISCLAIMER – All strategies listed here are not a recommendation nor advise. The article is written purely for the purpose of education and journaling only. The content of this article is an expression of my opinion and should not be taken as a professional advise. If you are seeking professional advise, please consult me personally . You should do your own research and/or seek an expert’s advice when overcoming your circumstances