Fundamental Concept of Investments – Capitalization

In this article you will find out how important it is to think long-term when making an investment. One of the most important concepts that characterize an investment, capitalization means multiplying the amount invested by a certain percentage after each period you take into account.

You are probably already familiar with bank deposits with interest capitalization. At such a deposit, after each period, usually annually, the bank offers you interest at the full amount of the deposit, not only at the initial amount.

Take a hypothetical example of a deposit of 10,000 $ , with an annual interest rate of 10%. After the first year, you will receive 1000 $ interest and the deposit amount will go up to 11,000 $ . Well, because the interest rate is capitalized, after the second year you will receive 1100 $ interest, and the value of your deposit will go up to 12,100 $ . Continuing with the third year, you will receive 10% of 12,100 $ , ie 1210 $ , and your deposit will contain 13,310 $ .

Long-term capitalization

At first glance, capitalization doesn’t seem to bring you much benefit. Even in the example above, after 3 years you only get 3310 $ out of 10,000. But over many years, the results change:

An amount invested in the amount of 10,000 $ with an annual yield of 15%, will be transformed after 10 years into an amount of about 40,450 $ . After 20 years, that investment will be worth 163,650 $ . An amount of 16 times higher than the initial one, and this in the conditions of an annual increase of only 15%.

But if we take an optimistic scenario, in which we make an investment with an annual yield of 20%? 10,000 $ will thus become 61,900 after 10 years, and after 20 years will be worth 383,300 $ . As you can see, even with a low annual yield, an investment makes very large long-term gains.

Why did we only consider relatively small annual returns? Because, as a rule, an investment promises higher returns, the more risky it is.

As you can see in the picture below, the returns obtained on the NY Stock Exchange since its establishment were quite volatile. They ranged from 106% in 2004 to -66% in 2008 (note, all yields are adjusted for inflation).

The importance of limiting losses

Although taking a higher risk may seem an attractive option when it comes to higher returns, this is not always the case. A negative yield will have to be offset by a higher positive yield. Let’s show you a conservative example first.

Suppose you invested those initial $ 10,000 in a few shares on the stock exchange, and in the first year you had a yield of -10%. Basically, at the end of the first year, your investment will be worth only $ 9,000. Well, in year 2, to get back to the initial amount of $ 10,000, you will have to have a yield not of 10%, but of 11.11%. Basically, the value of the investment will have to increase by $ 1000, which is 11.11% from $ 9,000.

The higher the one-year loss, the more you will have to earn more (percentage) next year to reach the original amount. Let’s take the most pessimistic scenario in the picture above, and think that we invested $ 10,000 on the stock exchange at the end of 2007, when the market was at its peak.

If we look at the picture, we see that during 2008 we would have lost 66% of the value of the investment, and we would have been left with an amount worth $ 3400. To turn those $ 3400 back into 10,000, we would need to get $ 6600, which means a 194% return. Basically, in 2009 the value of the investment should triple, just to reach the original amount.

To the end
A useful tool for calculating the value of an investment according to a certain yield after a certain number of years can be found HERE.

After all, when you build an investment portfolio, you mirror your attitude to risk. Some investors specialize in real estate investments, others on stock exchanges, and others diversify their investments with very low risk deposits and bonds.

In the next article I will present the main types of investments you can make in America, from speculative ones to low risk ones. Until then, I invite you to tell me your opinion about this article, along with any suggestions and additions.

Please SHARE what article you enjoyed and LIKE them, so I can prepare more interesting articles for you!

David Mead

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