Rate of Return: The Illusion of “Average” versus “Actual”

illusion_blog

If you’ve ever been fascinated by magicians, it’s probably because their illusions are incredibly believable and convincing. However, we all know that what they create are in fact illusions.

There’s another illusion out there in the world of investments and it has to do with your rate of return.

When we hear brokers, financial planners, or Wall Street talk about average rates of return, they are often referring to what the stock market has averaged over a historical period of time.

It is crucial to understand the difference between average and actual.

Imagine you invested $10,000 into a mutual fund and at the end of that year you end up earning 100%. You would now have $20,000. In year two your mutual fund doesn’t do well and you lose 50%. Now you’re back down to $10,000. In year three the market goes up and you earn 100% again. Now you have $20,000 again. But, in year four, the mutual fund loses another 50%, and after four years you are back down to the original $10,000 you started with. The investment would look like this:

Average Return: 25.00%

Actual Return: .00%

 

Year

Beg. of Year Acct Value

Earnings Rate

Interest Earnings

End of Year Acct Value

1

$10,000

100%

$10,000

$20,000

2

$20,000

-50%

($10,000)

$10,000

3

$10,000

100%

$10,000

$20,000

4

$20,000

-50%

($10,000)

$10,000

 

So, just how much money did you make over those four years? None!

You have exactly the same amount of money at the end of four years that you started with.

However, reality is that your actual rate of return after four years is zero. A mutual fund that advertised this performance could state, “Our fund has averaged 25% over the last four years.” It’s not illegal to state that, but, it is an illusion.

We have to understand that an “average” rate of return doesn’t mean anything.

Look at the “actual” rate of return to know exactly what is happening with your money and your investments.

Taxes, fees, volatility, and lost opportunity cost, will shrink an average rate of return even further. When making saving or investment decision, be sure that you know what your actual rate of return is versus your average rate of return. This will bring you more peace of mind regarding your financial plan and wealth strategies. To further this discussion, check out President Patrick Donohoe’s Pocast, Mutual Funds Analysis

Barry Brooksby

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