The average return: well known, little understood

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Would you be interested in learning a magic trick that could potentially save you a handful of money?  Allow me to set the stage for the attraction. 

Many investors consider past results (stated in average rate of return) as their primary rationale to employing an investment strategy. Countless studies conclude that reviewing past results remains the single most motivating factor for almost all investment decisions; yet many people innocently do not realize exactly how rate of return calculations actually function. 

Often times, prior performance statistics that we rely on may not be indicative of the bona fide past results! It is true and my example (magic trick) will prove it. While some say it is indeed magic, others say it is deceitful and misleading.

To underscore how historical performance is repeatedly a poor indicator of future results, a study was performed entitled “Dumb Money.” The authors of the experiment were professors at University of Chicago and Yale University, who discovered that between 1983 and 2003 the most desired mutual funds, those experiencing the greatest inflows of money, performed notably worse than mutual funds that investors were dumping.  Sounds like the proverbial buy high and sell low phenomenon, which regularly torments investors resulting from “chasing the dot,” (see my Nov. 1, 2012 column). 

Nevertheless, let’s take a look at this hypothetical example. On January 2, Harry invests $10,000 in the stock market (S&P5 500). At the end of the first year, the market advanced 100%. Therefore, Harry’s $10,000 is now worth $20,000. The next year, the S&P 500 drops 50%, which leaves Harry’s value at $10,000. The year three, the market makes another 100% advance, so Harry’s greenbacks are back to $20,000. However, the following year, the market heads south by 50%. In the end, after an incredibly volatile four years, Harry Benjamin’s are the same value as he started; $10,000. (See illustration above.)

I believe that we agree that Harry’s investment return is zero. However, here is where it gets disturbing for many, and that includes me! In other words, what was the average annual return for the market (S&P 500) during the four years?

How about 25% a year!

Yep! It is true!

Don’t believe me? Do the simple math. 100% -50% +100% - 50% = 100%. Now dived by four years to get to an average annual return of 25%! Regrettably, financial industry often uses the average return to make past returns look a little better than they actually were.  Although my investment delivered on its assurance of an average return of 25% a year over four years, you actually made no money!

Yes, your average return was 25% a year, but your actual return was zippo! The moral of the story:

Math is math. Money is money. Don’t succumb to the proverbial “average return” trap!

Note: The visual example is for illustrative purposes only. It is not possible to invest directly in an index.

Harry Pappas Jr. CFP®

Managing Director-Investments

Master of Science Degree Personal Financial Planning

Certified Estate & Trust Specialist ™

Certified Divorce Financial Analyst™

Pappas Wealth Management Group of Wells Fargo Advisors

818 North Highway A1A, Ste. 200

Ponte Vedra, Florida 32082

904-273-7955

harry.pappas@wellsfargoadvisors.com 

 

The use of the CDFA™ designation does not permit Wells Fargo Advisors or its Financial Advisors to provide legal advice, nor is it meant to imply that the firm or its associates are acting as experts in this field.

 

Wells Fargo Advisors and its affiliates do not provide legal or tax advice. Any estate plan should be reviewed by an attorney who specializes in estate planning and is licensed to practice law in your state.

 

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC, Member SIPC, a Registered Broker-Dealer and a non-bank affiliate of Wells Fargo & Company.

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