It is misleading to use the term ‘average returns’ instead of actual returns. Many financial planners and investment advisors use average returns to make an investment appear far better than it is. Let’s start with a simple example.
Let’s say that the stock market went up 30% one year and then declined 30% the following year.
Wall Street will claim that your ‘average return’ was zero (+0.30-0.30 = 0.00).
Really? Let’s examine what would have occurred with a $10,000 investment.
Year 1: $10,000 X 30% gain = $13,000 account balance at the end of year 1, a net gain of $3,000.
Year 2: $13,000 X -30% loss = $9,100 account balance at the end of year 2, a net loss of $900 or -9%.
So you actually LOST 9% of your money while financial planners using ‘average returns’ would tell you that you broke even.
The financial term is called the ‘sequence of returns’ and it makes a great difference in ACTUAL investment returns. Are large losses incurred with larger account balances or are large gains incurred with smaller account balances – then your actual returns will be far below the ‘average return.’
Here is a short sequence of actual stock market returns:
2004 +10.9%
2005 + 4.9%
2006 +15.8%
2007 + 5.5%
2008 -37.0%
The average return over this period was -0.10%, or about break even.
What would your actual return have been? -10.50%. So Wall Street, using ‘average returns,’ will claim that you just about broke even over 5 years but you actually suffered a loss of over 10%. This is because the 37% loss was incurred on a larger number than the first-year return of 10.9%.
An investment that offers a lower actual return, which is more consistently positive, will usually beat a more variable-return investment, even if they are periodically far higher returns. In the race between the tortoise and the hare, the tortoise’s returns are more robust and far more likely to win any race. When evaluating returns, it is best to ignore ‘average returns’ and use actual returns to determine whether or not it the risk/return provides a favorable location for your money.