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The faulty stock market perception can be illustrated with the following equations.
If you were to ask people what the average of 3 and 5 is, they typically respond as follows: (3 + 5 = 8)/2=4. The average is 4.

If you were then to ask them for the average of a negative 50 and a positive 50 they would do the equation the same way. So the typical investors assume that if they are getting positive returns and negative returns that they are still doing fine.

So what if you were then to ask them, “What is the impact of losing 50 percent one year and gaining 50 percent the following year? Back to your starting amount, right?” Actually, that would work out like this:

• $10,000 down 50 percent is $5,000
• Then up 50 percent is $7,500
• This is a 25 percent loss (13 percent annualized) after “offsetting” years.

Let’s look at an example in which the gaining percentage is greater than the losing one. A return of +66 percent followed by -50 percent would seem to add up to an 8 percent return. But actually:

• $10,000 up 66 percent is $16,600
• Then down 50 percent is $8,300
• +66 percent followed by -50 percent produces a negative 9 percent annualized return.

But look at the compounding gain of two 8 percent years:
$10,000 x 1.08 = $10,800 x 1.08 = $11,664

So, many people wrongly think that if they are getting a greater return than a loss, then they are doing well. But obviously that’s not true. Another misperception is just how deep a hole is created by losses. A 100 percent return would be necessary to offset a 50 percent loss. But a 300 percent return is required to offset a 66 percent loss. And then 400 percent for a 75 percent loss.

So, the next time you’re thinking about taking a risk, make sure you are doing an accurate mental accounting.

A mutual fund’s fees and expenses may be more important than an investor might realize. Ads, rankings and ratings will often emphasize how well a fund has performed in the past. But according to the Securities and Exchange Commission (SEC), studies show that the future often is different. Fees and expenses can be a reliable predictor of mutual fund performance.
When considering a mutual fund, one of the most important numbers is the expense ratio, which tells you how much the fund costs. The ratio shows how much of the fund’s assets are paid to the portfolio manager and for other operating expenses. Typically, a fund pays an average of 1.5 percent of assets annually.
Three things typically figure into this ratio. The investment advisory fee pays the managers of the fund, which accounts for .50 to 1 percent. Then, administrative costs cover services such as record keeping, mailing and maintaining a customer service line, which can range from .20 to .40 percent. And often a fund will charge a 12b-1 distribution fee, which covers marketing, advertising and distribution services. This ranges from .25 percent to 1 percent of assets.
The upper range of these fees shows how high an expense ratio can be. And even though the fee seems to be just a few percentage points, it is charged in down years, when it can represent a significant slice of the return. Also, over time, the fee can cut the ultimate return by nearly 50 percent, according to one analysis. With an initial $10,000 invested after 30 years of 10 percent returns (a bit optimistic, perhaps), the fund has made $174,494, but with a 2.5 percent expense ratio, it has lost $86,944, according to an analysis by Moolanomy.com.
But even that isn’t the bottom line. There are still transaction fees incurred by the buying and selling of assets in the fund that go unreported, and that can double or triple the cost, according to Richard Kopcke of the Center for Retirement Research at Boston College.
Of the 100 largest stock funds held in defined contribution plans as of December 2007, trading costs averaged from 0.11 percent of assets annually in the quintile with the lowest costs to 1.99 percent of assets in the quintile with the highest costs, with a median of 0.66 percent, Kopcke found. But it is difficult for average investors to determine this percentage, he said.
The SEC has not been able to develop ways to report this percentage in the same way an expense ratio is reported, partly because fund managers say the number is too difficult to determine. One way to get an indication of the percentage is the fund’s turnover. The percentage of turnover shows at what rate stocks in the fund have been replaced. A high turnover rate would mean more fees.
The SEC last year required fund managers to disclose one year of turnover at the front of a prospectus in addition to the already required five years of turnover disclosed in the financial highlights section, according to a March 1 Wall Street Journal article. Turnover of more than 100 percent can indicate trading costs may be high, the Journal reported.

Derivatives protect people from a change in prices of an underlying asset. They began, generally speaking, as a hedge against changes in commodities prices. So, if you are a corn farmer and want to be able to plan on how much you will receive for your crop, you can agree on the price with a miller. The farmer is in a sense betting that the price will be higher or at least the same as the rest of the market at harvest time, and the miller is betting that the price will be lower or at least the same – and the miller is ensured of a supply of corn. The result is stability for both parties. The agreement is derived from the underlying asset of corn. That is the essence of a derivative.

Derivatives also hedge against price changes in other financial instruments and can become far more complicated or “exotic.” An institution can buy a credit default swap (CDS), for example. Institution No. 1 would pay institution No. 2 to ensure that the value of an asset does not fall under a certain level. If the value does drop, then No. 2 would pay No. 1. When the value of real estate plummeted in 2007 and 2008, many No. 1 institutions were banging on No. 2 institutions’ doors to get paid. This was one of the factors leading to the economic collapse, when the overall value of the CDS market dropped from $62.2 trillion at the end of 2007 to $38.6 trillion at the end of 2008, according to the International Swaps and Derivatives Association.

Another factor was collateralized debt obligations (CDOs). These are packages of debts such as bonds or mortgage-backed securities. The idea is to reduce risk by spreading it around. But some in finance, such as Warren Buffett, said that they instead spread risky investments to more institutions. So when the underlying, or derived, asset plummeted, the rug was pulled out from under everyone.

Although some, like Buffett, had sounded the alarm on derivatives, many people were surprised by the enormous impact the instruments had on the financial sector in the collapse of September 2008. Regulators were also surprised, because derivatives are often unregulated because they are essentially an agreement exchanged between parties but amount to a $400 trillion market traded over the counter (OTC).

Financial reformers want to shed more light on the market, but on April 21, a Senate committee went even further than that and approved tough standards that would force banks to get rid of their swaps trading operations. That rule might not make it to the final financial reform package, but it is certain that the eventual law will clamp down on derivatives in some way.