Do you know the difference between average and actual rate of return in an investment? If not, you are probably losing a lot of money without realizing it. When you get the statements in the mail from your 401k or mutual fund and you see the percentage of how much your portfolio made or lost, do you know what they are talking about? One very important thing to understand is the difference between average and actual rates of return.
First of all what is rate of return? The dictionary defines it is “The gain or loss of an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security, plus realized capital gains.” Or, in real simple language it is how much your investment is making. But when you see that your portfolio has earned 8% for the past few years, what does that really mean? Is that an average rate of return or is it the actual rate of return?
Let me give you a very simplified example over four years to illustrate this point. Suppose you start off with $1,000 to invest. You put it into the market and have a great year, earning 100% for the first year. At the end of the year you would have $2,000 in the account. In year two things don’t go so well and your portfolio loses 50%. At the end of year two you would have $1,000 in your account. In year three things go fantastic and you earn 100%. At the end of year three you would again have $2,000 in your account. Then in year four things look bleak again and you lose 50%. At the end of year four you have $1,000 in your account. Your spreadsheet would look like this:
- Starting Balance Year Annual Rate of Return Year End Balance
- $1,000 1 100% $2,000
- 2 -50% $1,000
- 3 100% $2,000
- 4 -50% $1,000
What do you notice as you look at this spreadsheet? The biggest thing that should jump out to you is the balance in the account. You see that your beginning balance and your ending balance are exactly the same. So how much money have you made over those four years? ZERO!!! You have exactly the same amount at the end of four years that you started with. So what is your actual rate of return for the four years? That’s right, it is ZERO!!!
Now here is the real kicker. What is your average rate of return for those same four years? To figure this out, add up all the rates of return for each individual year and divide by four. If your calculator works the same as mine you should also come up with an answer of 25%. Wow! A 25% rate of return is great! Anybody would be dying to get a 25% rate of return in their investments.
Well guess what? A mutual fund that had this exact performance could advertise in print “Our fund has averaged 25% over the last four years!” That is a true statement. It is not deceitful, illegal, misleading, dishonest or anything. But with that 25% average rate of return, how much money did you actually put in your pocket?
So which is the most important to you, the average or the actual rate of return? Obviously the answer is the actual rate of return. Who cares that your portfolio averaged 25% over the last four years if you didn’t make any money? And remember, this is an oversimplified example. In real life there are also management fees, fund fees, taxes, inflation, and other costs that have to be factored into the actual rate of return.
As you can see from this example, having an understanding of the difference between average and actual rate of return is critical. Knowing how to spot the difference between them will make a huge difference in your retirement. Instead of retiring and wondering where all your money is, you will have both your money and peace of mind.