Investing, Retirement Planning

Share on facebook
Share on twitter
Share on linkedin

What’s the Difference Between Average vs. Actual Rate of Return?

If an investment adviser touts an impressive average rate of return, be very wary, because losses can “hide” among the gains and hinder your financial success. Let’s explore the meaning of average rate of return vs. actual rate of return.

Your most compelling reason to make an investment choice most likely may be based on one performance criterion: rate of return. But are you looking at it the right way? When meeting with potential clients, I’ll often get asked what kind of average rate of return they can expect. But if you are relying on the average rate of return, you’re making a big mistake. Be careful to not fall prey to this type of thinking and possibly get taken advantage of.

There are actually two different types of rate of return, and they are not created equal: average rate of return and real, or actual, rate of return. The worst result of making investment decisions without understanding how rates of return work, coupled with how the rates are affected by sequence of returns risk, is that you could drastically shorten the amount of time that your money will last in retirement.

What is the average rate of return?

The average rate of return is a simple calculation: Add up all of your annual investment returns and divide them by the time commitment. Financial advisers often use the average rate of return as an advertisement for whatever product they are usually pitching.

For example, let’s examine the following $100,000 investment over a five-year period:

Year 1 = $107,000 (7%)
Year 2 = $114,490 (7%)
Year 3 = $122,504 (7%)
Year 4 = $131,080 (7%)
Year 5 = $140,256 (7%)

As you can see, after five years, the investment had an average rate of return of 7%. This was accomplished by adding up each annual return and dividing that number over the five-year period. In fact, I often see projections from other financial advisers that use almost verbatim the example above. But you know there will never be a five-year period where investment returns will be exactly the same each year.

What many might not realize with an average rate of return is that due to the nature of the calculation, gains during some years can obscure losses in others. The end result is that while an average gain may look good, it may leave you with less money in your pocket than expected. For example, shares of Walmart (NYSE: WMT) returned 9.1% in 2014, lost 28.6% in 2015, gained 12.8% in 2016, gained 42.9% in 2017, and lost 5.7% in 2018. The average return of Walmart stock over those five years is 6.1% (30.5% ÷ 5 years = 6.1%). Any type of stock, bond, or mutual fund investment will always have both gains and losses.

What is the actual rate of return?

The actual rate of return is a process of recalculating and adjusting investment returns to account for both gains and losses.

For example, let’s examine the following $100,000 investment over a five-year period:

Year 1 = $120,000 (20%)
Year 2 = $130,800 (9%)
Year 3 = $107,256 (-18%)
Year 4 = $116,909 (9%)
Year 5 = $134,445 (15%)

Once again, after doing the math, you will see that after five years, this investment also had an average rate of return of 7%. The key distinction is the end result of $134,445, or an actual rate of return of almost 6.1%, is almost $6,000 less than the previous example of $140,256. Here are the calculations for reference:

$134,445 ÷ $100,000 = 1.34445
1 ÷ 5 = 0.2
x(^)n = 1.344450.2 = 1.060984235637
1.060984235637 – 1 = 0.060984235637
0.060984235637 x 100 = 6.0984235637% or ≈ 6.1%

The bottom line: the actual rate of return is a lot more revealing

Investors should be interested in the actual rate of return – not an average – as investment losses can be easily hidden by using an average rate of return.

If you viewed this as only a simple equation, then there isn’t any difference, as both examples ended up averaging 7%. However, from an actual investment value, including both gains and losses, there is an obvious disparity.

When working with a financial professional touting their average rate of return, request that they show the performance with actual dollar amounts.

How sequence of returns risk affects rate of return

As we age, the risk of loss can substantially diminish the ability to make our money last in retirement. According to an Allianz Life, 63% of Americans fear running out of money in retirement more than they fear death.

While losses might not impact us during the accumulation stage in our working years, they will definitely hurt us in our distribution stage in retirement.

Let’s use the previous two examples but include an annual $4,000 withdrawal:

Example #1:

Year 1 = $107,000 (7%): $4,000
Year 2 = $110,210 (7%): $4,000
Year 3 = $113,645 (7%): $4,000
Year 4 = $117,320 (7%): $4,000
Year 5 = $121,252 (7%): $4,000

Example #2:

Year 1 = $120,000 (20%): $4,000
Year 2 = $126,440 (9%): $4,000
Year 3 = $100,401 (-18%): $4,000
Year 4 = $105,077 (9%): $4,000
Year 5 = $116,239 (15%): $4,000

Per the results above, the first example was still $5,000 ahead of the second one after withdrawals were accounted for. As a result, one loss changed the balance at the end of the fifth year, even though the average rate of return was the same.

Holding losses to a minimum with proper investment allocation, especially when approaching retirement, can have a significant impact on your financial success rate.

About the Author

carlos-img

Carlos Dias Jr.

Carlos Dias Jr. is a financial advisor, public speaker, and president of Dias Wealth, LLC. Carlos is a nationally syndicated contributor for Kiplinger and has contributed, been featured, or quoted in several publications including Forbes, MarketWatch, Bloomberg, CNBC, The Wall Street Journal, U.S. News & World Report, USA Today, and others. He’s also been interviewed on various radio and television stations. Carlos is multilingual, fluent in both Portuguese and Spanish.

Investing, Retirement Planning

Share on facebook
Share on twitter
Share on linkedin

Posts not found.

Carlos is a very professional and knowledgeable financial planner. He focused on my financial goals and answered all my questions. He helped me better understand my future retirement plans, as well as how my life insurance policy was set up. Truly thankful for Carlos and his team.

Posted On

Google

Enter your email address receive notifications of new posts and videos by email.

This field is for validation purposes and should be left unchanged.

Starts

Starts Today

REQUEST YOUR COMPLIMENTARY CONSULTATION
NOW. CONFIDENTIALLY IS GUARANTEED.