Average vs Real
Do you ever feel like every investment you entered into looked great on paper but never seemed to perform as it was illustrated?
Investigate your investments and the managers in charge of them. They may not be what they seem. A case in point of this is the term “average rate of return” which is widely used in the investment industry. Let’s take a closer look at what it means.
What would your average annual rate of return be if you were to invest $100,000 in stocks over a four-year period of time, with an immediate -50% crash in year one, followed by +50% in both years two and three and then a -30% crash in year four? Add up the numbers and then divide the total by 4 (years). You would get an annualized return of 5%. Thus, promoters of this investment could advertise that they made a 5% average annual rate of return.
| Year 1 | -50% |
| Year 2 | +50% |
| Year 3 | +50% |
| Year 4 | -30% |
| Total | +20% divided by 4 years = 5% average annual rate of return |
But wait, let’s find out what you actually earned by looking at what your balance is at the end of each year:
| Initial investment | $100,000 |
| End of year 1 with -50% | $50,000 |
| End of year 2 with +50% | $75,000 |
| End of year 3 with +50% | $112,500 |
| End of year 4 with -30% | $78,250 = Your real return was a net loss of $21,250. |
BEWARE of those funny numbers.
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