Within the investment industry such as mutual funds, indices, ETFs, individual stocks, variable annuities, REITs, variable universal life insurance, and other products tied to the stock market, the industry as a whole advertises using the average rate of return.
“Why is this a problem?”
The average return or arithmetic mean is a simple calculation. If you don’t already know, it works by adding up all the annual returns and dividing them by the number of years (or whatever sample you are using).
In the investment world, the simple average is a way to smooth out the affects a loss can have on a portfolio, and the industry loves to advertise these average returns to the public because of how it inflates their numbers.
The Actual or “real” rate of return is achieved by adding/subtracting the annual return each year and then starting each year with the new value. This is also referred to as either the geometric mean or the compound annual growth rate.
The reason why you don’t hear about this number is because it is always lower than the average.
Here is an example:
Ed invests $100,000 into a mutual fund and at the end of the first year his account grew by 20%, and the second year his account had a return of -20%. The marketed average return would be 0%. This is the number the industry will have you looking at, but who cares about the average return…we need to know how the actual investment performed through that same period.
Again, with an investment amount of $100,000, multiplied by its return of 20% equals $120,000 at the end of year one. Year 2, $120,000 multiplied by -20% equals $96,000. After the two years Ed’s actual return was -4%.
How can someone have less money than when they started, when the average return was 0%?
When you lose money, you have that much less capital in order to generate returns during the following years, and the impact of a loss has a much greater influence on your portfolio than a gain.
Head over to moneychimp.com, there is a neat calculator where you can see for yourself how the numbers are.
The point is, the “actual return” is the ONLY return that really matters. It gives you the ability to see how an investment truly performed over time, by taking into effect the gains and not masking the impact of losses.