Average Rate of Return vs Actual Rate of Return

Rate of return. Rate of return. Rate of return.

One of those hot phrases that gets thrown around often. Let’s first start by defining what rate of return means; according to the SEC.Gov website the annual rate of return is the percentage change in the value of an investment. They use an example of a $1,000 investment and if your annual rate of return is 10%, you would expect at the end of the year that your $1,000 would have grown to $1,100 ($1000 * .1 = $100 increase added to the initial investment).

Let’s stick with this $1,000 example.

Year 1 we have a 10% annual return which took our investment from $1,000 up to $1,100.

Year 2 doesn’t go too well, and we end up having a -10% annual return. So, now we lost part of our investment. -10% on $1,100 is loss of $110, which would make our total at the end of the year $990.

Wait a minute…

We had a positive 10% in year 1 and then a negative 10% in year 2. How is the current value less than what was initially invested?

Our average return here would be 0% since we have 10% + -10% = 0% / 2 years. However, when we examine our actual return, we are -1% since we are -$10 over the 2 years.

Let’s do this for another 2 years and let’s reverse the order, where we go -10% in year 3 and then back up 10% in year 4.

$990 * .1 = $99. $990 – $99 = $891 end of year 3.

Now, a positive 10% return.

$891 * .1 = $89.1. $891 + $89.1 = $980.1 end of year 4.

After 4 years our initial investment of $1,000 has dropped down to $980.1 with yearly returns of 10%, -10%, -10%, and 10%. These 4 years have an average rate of return of 0% and yet we don’t have $1,000 anymore.

The real return is right under -2% for the examined time frame. Why is this important?

Most investments are going to quote in terms of an average rate of return for a certain period of time and that’s because the numbers tend to look better. What does an average actually mean? 50% of the time the return will be higher and the other 50% it will be lower. The only (biggest) problem is we don’t know which 50% it’s going to be from year to year.

Understanding the average return of an investment is good knowledge to have. Assuming that average return is going to happen each year, continuously for the next 10, 20, or 30 years in a row, not as much.

Book an introductory meeting to talk more or email me, paul.williams@rethinkwealth.com!

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