Mutual fund salesman, stock brokers, insurance brokers, and countless Certified Financial Planners rely on something called "average rate of return" when selling investment ideas. Nearly every mutual fund in existence displays the "average rate of return" of their fund as opposed to the CAGR or "compound annual growth rate".

When you talk to your financial adviser, he or she is taught by a variety of educational institutions to use an averaging method or randomization method (i.e. the "Monte Carlo Method"). Her brokerage firm also encourages using average return assumptions in illustrations as well as "hypothetical" return when talking to clients.

So, from very early on, we are all taught to average our investment returns. However, this can very quickly become the financial kiss of death.

Let's take a quick look at what averaging will do for you:

Invest $1,000 in a financial product that averages 8% annually.

It can look like this:

Yr 1 - $1,000 x 8% = 1,080
Yr 2 - $1,080 x 8% = 1,166
Yr 3 - $1,166 x 8% = 1,260
Yr 4 - $1,260 x 8% = 1,361

Your average rate of return is 8%. But, what about your compounded annual return? The compounded annual return or compound annual growth rate is the REAL rate of return. It represents the actual amount of money you make, compounded over the number of years you've been investing. While averaging will smooth out interest rates, it will also tend to inflate your returns if there has been a major correction in the stock market. In this example, your actual compounded annual return is 8%.

BUT...

This scenario assumes an "ideal" situation in which you are earning 8% each and every year (something that has never happened and is unlikely to ever happen due to the nature of the business cycle and the monetary inflation that accompanies it).

A more realistic illustration of an average 8% return might look like this:

Yr 1 - $1,000 x + 40% = 1,400
Yr 2 - $1,400 x + 22% = 1,708
Yr 3 - $1,708 x - 15% = 1,450
Yr 4 - $1,450 x - 15% = 1,233

Even though the first 2 years in this illustration show an extremely high rate of return, the relatively small losses (in comparison) magnify the losses on a larger amount of money. This means that your average rate of return in this example is once again 8%. But your actual compounded annual return is only 5.38%.

And, just in case you're wondering, this isn't just a phenomenon that happens with an 8% return either. It's a phenomenon that is built into the nature of averaging and percentages. Here's a different example, using $100,000 and an average of 12% this time:

Yr 1 = 20% = $120,000
Yr 2 = 4% =   $124,800
Yr 3 =  -10% =  $112,320
yr 4 = 24% = $139,276
yr 5 = 22% = $169,916

Now, let's repeat this example but use a straight 12% rate of return:

Yr 1 = 12% = $112,000
Yr 2 = 12% =   $125,440
Yr 3 = 12% =  $140,492
yr 4 = 12% = $157,351
yr 5 = 12% = $176,234

Now, let's compare that with another scenario involving one down year in which you lost a catastrophic 40% (similar to what many people are going through right now):

Yr 1 = 25% = $125,000
Yr 2 = 30% =   $162,500
Yr 3 = 20% =  $195,000
yr 4 = 25% = $243,750
yr 5 = -40% = $146,250

Now, stretch this out over 20 or 30 years. All of these scenarios average 12%, but give you actual compounded returns that are all over the place. This is, in part, due to the fact that a percentage deals with the actual dollar amount indirectly instead of directly. It discounts when you receive the money-which is critically important in investing (which you can see from the examples above).

I could actually continue to play with more numbers, but I think you get the point. Don't you love the creative nature of averaging?

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This entry was posted on February 15th, 2010 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Investing