Average Rate of Return

Investing is all about benchmarks. Too often in investing, we focus on the wrong benchmark. The benchmarks we choose to focus on can determine our success or our failure. To be successful, we must choose the right benchmarks’, to do that, we have to understand what different benchmarks actually mean. 

Average Rate of Return and Actual Rate of Return are two benchmarks often used for investing.  

What is an Average Rate of Return? 

Average returns are annual returns that are averaged out over time. 

Here is a basic example of Average Return, using an investment of $100,000: 

  • Year 1: 25 % Loss
  • Year 2: 25% Gain
  • Year 3: 60% Loss
  • Year 4: 100% Gain

The average over 4 years is 10%. Sounds good, huh? 

This is not the entire picture. Using “average rate of return” as a decision-maker overusing the average rate of return has a significant flaw.  

These gains are relative to the amount that has remained invested at the beginning of the year. Consequently, each subsequent year’s actual gains and losses are impacted by the gains and losses of the previous year. 

What is the Actual Rate of Return

Defines the exact performance of your capital from a start point to the endpoint. 

What is more important?

When an investor is choosing an investment, they need to be aware that the “average rate of return” is misleading.  The actual rate of return is almost always more accurate and is the number an investor should place a higher priority on. 

Using the beginning balance above $100,000, how do you think an investment that gets 5% a year return each year compares to the 10% average? This may surprise you.

Beginning BalanceReturnGross ReturnEnding Balance
Y1$100,000(25%)($25,000)$75000
Y2$75,00025%$18,750$93,750
Y3$93,750(60)($ 56,250)$37,500
Y4$37,500100$37,500$75,000

 

Beginning BalanceReturnGross ReturnEnding Balance
Y1$105,0005%$5,000$105,000
Y2$105,0005%$5,250$110,250
Y3$110,2505%$5,512.50$115,762.50
Y4$115,762.505%$5788.12$121,550.63

 

Which Account would you rather put your money in? The account that earns 5% a year, right? That is a difference of $46,550.63 in only 4 years. Imagine what this could look like over the course of your lifetime.   

This is an account that pays compounding interest. It is a financial vehicle most of us have heard of, but few understand. Contrary to the popular myth, the stock market does not have compounding returns. Compounding returns can only be created when there is never a loss. 

What is the Difference? 

The difference is the Average Rate of Return vs the Actual Rate of Return. 

  • The difference between them: LOSSES
  • Anytime you have a single year of losses, your average return will not equal your actual return.

Average Rate of Return

  • When calculating average return, gains and losses carry equal weight.
  • Losses have a greater weight and impact on your actual dollars than gains do.
  • To be relevant, you need to know the time period in which the averages are taken from.
  • Average returns unnecessarily focus on the incremental changes between years, losing sight of the big picture

 

Why are we taught to focus on “Average Rate of Return” when it comes to our investments? 

The average rate of returns tends to be promoted by investment companies because the numbers typically look better. It gives the illusion that an investment will be more profitable than it really is. 

When most folks look at retirement planning their focus is on the average rate of return. Assumptions we make about how much money we will have in a retirement portfolio is based on Average Rates of Return. Average returns are often taken to mean that you received the average return every single year and never have a loss. The impact of losses is never taken into consideration. As you can see from the example above, losses do make an impact on your total return. 

The average rate of return is a performance measurement. You cannot spend rates of return. It’s not real until you pull it out.

Without an understanding of the difference between the average rate of return and the actual rate of returns, you risk massive failure. 

  • Half the time, returns will be below average
  • Do you want a plan that only works half the time?
  • This is a misleading term 
  • In one 10-year time period, may get 10 %
  • In the next, may get 5%

Some Additional Examples of  “average Rate of Return” VS Actual Rate of Return

If you invest $1,000 one time and receive an average of 20% Return for two years, how much would you have? It depends what you gained in year one and it depends on what you gained in year two. 

  1. $1440 B. $1280 C. $800 D. $0

Year 1: Your account gains 20%

A gain of $200 End of Year Balance: $1,200

Year 2: Your account gains 20%

  Gain $240 (.20 x $1,200) End of Year Balance: $1,440

Your average gain is 20% and your Actual gain is 20% each year, or $440

Let’s change those numbers a little

Year One: 60% Rate of Return

Gain: $600 ($1,000 x .20) End of Year Balance: $1,600

Year Two: Your retirement account Loses 20%

Loss of $320 ($1,600 x -.20) End of Year Balance: $1,280

Your average gain is 20% and your actual gain is 

The third time is a charm

Year one: 100% Rate of Return

Gain: $1,000 ($1,000 x 1) End of Year Balance: $2000

Year Two: Your Retirement fund loses 60%

Loss of $1,200 ($2,000 x -.60) End of Year Balance: $800

Let’s try this one last time

Year 1: Your Retirement fund makes a 140% Rate of Return

Gain: $1,400 End of Year Balance: $2,400

Year 2: Your Retirement fund loses 100%

Nothing is left

Your average return is 20% but your real return is a loss of $1000 from year 1 and $1,400 from year 2.