Suppose you have made an investment three years ago at a cost of 100. Today, say the investment is worth 160. Your rate of return for 3 years is 60% and your compounded annual rate of return is (160/100)^(1/3) =16.96% per annum.
Suppose you expect the investment to go upto 165 in another quarter but under some risk that it may also go down, what do you do and what should you do?
At the rate of 165, your profits would be 65 instead of the previous 60, at a new annualised rate of return of 18.16% from the previous ~17%. Should you now go for it?
It sure looks tempting to get a rate of return of 18.16% with a little risk, but this is identical to driving a car looking at the rear mirror. Let me explain. There are two ways to look at the rate of return. One rate of return based on the investment done 3 years ago and one assuming you are investing today. With the old investment, yes, your calculation comes to an attractive 18.16%. But assuming you are investing 160 today, you are expecting a rate of return of a mere 5/160= 3.125%. The truth is that you have already made most of your money till now and your marginal rate of return is only some 3 odd %.
By keeping the investment, the truth is that you are actually wanting to make an investment giving a rate of return of ~3 % in a quarter with the risk of a downside too and not the 18.16% per annum that the calculation shows. The question to be asked is "Is this what you really want when you could have other more worthwhile investments to make which can give you better returns?".
The comfort of previous returns makes people biased to calculating from a historical perspective and make them feel that the investment is good. By doing so, you are indifferent to reinvestment opportunities and are missing real opportunities that will make you more money.
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