Average Returns vs. Annualized Returns... and Why It's So Important
One of the most misunderstood concepts in investing is also one of the most damaging in its misuse. If you don’t understand this concept you are bound to fail financially, or at least underperform your own expectations, simply because you don’t understand the math.
Does This Conversation Between a Financial Professional and a Client Sound Familiar?
"Well, the stock market generally has averaged a return of 7% over the last 25 years. Of course, past performance can’t guarantee future results, but how about we just project a 6% return in our planning? That’s more conservative, right? OK great, just sign this paperwork…”
Chances are you’ve heard a similar proposal. The numbers may be a bit different but the concept is to plan to achieve a little less than the average over time, and then call it conservative.
Let’s analyze this type of investment strategy:
What Does the Stock Market Average?
Can the stock market average anything? Does the S&P 500 generate a return? NO. This is important. There are index funds that attempt to mirror the S&P 500. But you can’t invest in the index itself, only a fund that tries to mirror it, or any index for that matter. There are inefficiencies in this. So, if you look at the S&P index over time, you’re not looking at a rate of return – you’re looking at a change in an index. There is a difference.
Your Investment is Different from the Index Your Fund is Trying to Mirror
The most important two ways are TAXES and FEES. Even if an investment is tax-deferred or after-tax (ie. a Roth IRA), funds themselves have internal taxes when they realize capital gains inside the asset itself, as well as an assortment of fees. Both of these differences can drastically reduce the actual performance of your investment. Fees alone can produce an ongoing 1.5% compounding handicap on your investment, and taxes will pull down your performance even more. Therefore, in reality, even if the index were to earn a healthy 8% over time, your “index” might be more like 6% when adjusted for taxes, fees and the fact that index funds generally lag the indexes they’re trying to mirror.
But here’s the most important distinction between average returns and annualized returns, and we'll tell you the key to it up front: VOLATILITY.
Deceptively Simple Math
You invest $100 into an investment and let it ride for two years. In the first year the investment doubles, it goes up 100%. The 2nd year the investment loses half its value, or 50%. How much do you have at the end of the 2nd year? If you didn’t come up with $100, check your math and do it again. If you came up with $100, here’s the next question: what is your rate of return on the investment?
If you look at it this way, when you consider the actual performance of your investment, you can easily see that the two-year rate of return is 0%. You started with $100 and you have $100 two years later. But what is the average rate of return of the investment itself? 25%! In Year 1 it grew 100% and in Year 2 it lost 50% for a total of a 50% rate of return over 2 years. Divide the 50% by 2 for an average two-year rate of return of 25%.
Year 1: $100 x 2 = $200 --> 100% return
Year 2: $200 x 0.5 = $100 --> 50% loss
+100% - 50% = 50%
50% / 2 years = 25% average rate of return
Had your investment behaved like the average, your $100 would have grown to $125 in the first year and $156.25 in the second year. But instead you’re sitting at $100, an actual return of 0%, a big, tasteless donut. Your actual performance lagged the “index” by 56%!
While this example uses what could be considered extreme percentages, it doesn’t matter. The financial concept is the same. When you lose money, it takes a greater percentage of return just to get back to even. Once volatility is introduced, and volatility always exists in the stock market, average and annualized rates of return diverge. The more the volatility, the more the divergence. This is the danger in looking backwards at averages and then projecting forward with your investments. They notoriously under-perform the indexes, and then there are taxes and fees on top of that. If you've been paying attention, you will notice that volatility has become the norm, not the exception.
Lack of understanding and application of this simple math concept confounds investors and leads to disastrous results. By the way, individual investors aren’t the only victims of faulty math assumptions when doing financial planning. This happens at all levels of government, and is one of the many reasons government pensions are consistently underfunded. What matters is not the average return of the investments you have, but YOUR ACTUAL return. Those are different, and we can show you how applying this concept correctly, or incorrectly, can affect your retirement.