Average and Actual Returns. What's the Difference?
InsightsYour financial advisor has just left after reviewing your investments with you. Year after year you keep seeing what looks like a great rate of return on your portfolio, but the volume of money doesn’t seem to point to the same conclusion.
What is going on?
Rate of return can be deceiving and is calculated a couple ways.
Average.
This is misleading because down years hurt you more than up years help you.
Why?
The down years are calculated on a larger bucket of money than the up years. Here is a very simple example for you.
Imagine you have $100,000 (smaller bucket) and earn a 100% rate of return your first year in an investment. This puts you at $200,000 (larger bucket). Now imagine in the second year your investment experience is not so good, you lose 50%. Your back at $100,000. Your average rate of return is 25% though. A positive 100% minus a negative 50% leaves us with 50% to be divided by 2 investment years, equaling 25%.
You may now be thinking that the order of returns matters too for this average rate of return. Believe it or not, it doesn’t if the only thing we are looking at is where we end up at the end. (This order of returns makes a huge difference when withdrawing money in retirement for example though, it’s called sequence of returns risk)
Check out this example in the charts below. You invest $10,000 1 time and let it work for 5 years.
Year | Beginning of Year | Rate of Return | End of Year |
1 | $10,000.00 | 50% | $15,000.000 |
2 | $15,000.00 | -25% | $11,250.000 |
3 | $11,250.00 | 50% | $16,875.000 |
4 | $16,875.00 | -25% | $12,656.250 |
5 | $12,656.25 | -30% | $8,859.375 |
Average Rate of Return: 4%
Year | Beginning of Year | Rate of Return | End of Year |
1 | $10,000.00 | -30% | $7,000.000 |
2 | $7,000.00 | -25% | $5,250.000 |
3 | $5,250.00 | -25% | $3,937.500 |
4 | $3,937.50 | 50% | $5,906.250 |
5 | $5,906.25 | 50% | $8,859.375 |
Average Rate of Return: 4%
To find average rate of return you simply add the positive numbers and subtract out the negative numbers to come up with a total (50+50-30-25-25=20), then divide by the number of years (20 is our total number/5 years of investing=4). I showed the rate of return in different orders just to prove it’s not a trick. Both cases end with an average rate of return of 4% but had a negative actual rate of return.
Actual.
The actual rate of return is much more useful than average. You will often hear actual rate of return referred to as compound annual growth rate.
When talking actual rate of return you are accounting for the fact that down years hurt you more than up years help you. Average does NOT take this into consideration.
Look below at what an actual 4% rate of return produces. This is a 1 time $10,000 investment working for 5 years.
Year | Beginning of Year | Rate of Return | End of Year |
1 | $10,000.0000 | 4% | $10,400.0000 |
2 | $10,400.0000 | 4% | $10,816.0000 |
3 | $10,816.0000 | 4% | $11,248.6400 |
4 | $11,248.6400 | 4% | $11,698.5856 |
5 | $11,698.5856 | 4% | $12,166.5290 |
Actual Rate of Return: 4%
Average Rate of Return: 4%
Year | Beginning of Year | Rate of Return | End of Year |
1 | $10,000 | 20.000000% | $12,000.000 |
2 | $12,000 | -30.000000% | $8,400.000 |
3 | $8,400 | -40.000000% | $5,040.000 |
4 | $5,040 | 100.000000% | $10,080.000 |
5 | $10,080 | 20.699692% | $12,166.529 |
Actual Rate of Return: 4%
Average Rate of Return: 14.1399384%
As you can see in the charts above, actual rate of return stays the same even when there are huge swings up and down.
An actual rate of return tells you what you would have to earn every single year in the investment to end up where you are at the finish. I added the average rate of return on these to show again just how misleading it can be.
Other factors that may affect the volume of money you end up with.
Keep in mind when you are having money managed by a financial firm there are usually fees associated with your account. There is a wide range so I won’t attempt to tell you what they might be here, but if you are interested in learning about them here is an article. It is from 2011 and does a great job of describing what the fees are. (This article is found on Forbes and focuses on mutual funds. It is written by Ty A. Bernicke)
Depending on your type of account, you could also have taxes due when investments are sold. This money can either come from your investment account or out of your pocket to leave the money working in your investment.
At the end of the day what really matters?
You can associate a rate of return with anything, but isn’t the volume of money you control what’s important?
I urge you not to get so caught up in rates and spend more time looking at how much of the money in your account is actually yours to use. If you have qualified plans (not ROTH’s), remember that taxes are due when you pull money out, so some of what you see isn’t really yours. This also goes for stocks, mutual funds, etc.
When we present infinite banking policies to potential clients, we focus on the volume of capital that you are in control of.
Remember that the volume of capital you control is the most important thing, and if you worry about this, you won’t even have to worry if your advisor is talking about average or actual rate of return.