Did Your Broker Mislead You? Why Average Returns Don’t Equal Real Rates of Return
Let’s examine one of the “unintended consequences” of volatility: poor returns that don’t match expectations.
There’s a dirty little secret in the financial world, and it’s this: the average rate of return doesn’t equal actual rate of return, regardless of who may have promised you otherwise. And yet, brokers and typical financial advisors love to throw out averages because they’re technically true.
Yet technically true isn’t enough to base your entire financial strategy on. It’s important to dig deeper if you want to understand why averages often fail to reflect your lived experience with the stock market. That’s where CAGR comes in, or your Compound Annual Growth Rate.
We often discuss CAGR/compound growth vs average growth rate with clients, readers, and other advisors so they can understand why investments rarely grow as much as you expect! In fact, my husband, Todd Langford, developed financial calculators that can prove this concept (check out the video below).
This average vs. actual concept is why money earning an average rate of return of 10% might actually grow by only 7 percent per year! There’s no doubt the wonder of compounding interest has helped many people grow fortunes large and small. Yet the compound annual growth rate (CAGR) is constantly being confused with average rates of return. In this article, we’ll look at a new way of expressing this truth, and why it matters to you.
Why Average Has Such a Large Impact
To get to the root of WHY an average return isn’t really “real,” we have to pick apart what the rate of return is, as well as what “average” means.
How do you get an “average” number? You have to examine a data set over a period of time, add those figures up, and then divide the number by that time period. For example, if you want to look at the average rate of return over five years, you would add up the ROR over that time frame and then divide it by 5. That gives you the average. While many people use this number to reflect how well something is doing, it doesn’t do a great job of reflecting major up or down swings.
Your compound annual growth rate, on the other hand, is a reflection of the actual increase you experience. Rather than making a calculation based on the rate of return, you instead calculate the growth rate based on where you started and where you ended in a given time period. This provides you an accurate ROR because it’s a reflection of the REAL growth you experience. (In Truth Concepts, you can do this calculation with a Rate of Return calculator.)
1. Compound Annual Growth and Average Won't Match
Although you can argue that both your CAGR and your average return are calculated from “real” numbers, the two won’t match. There’s one exception, and that’s if your asset earns the exact same interest rate each year. The question is, why wouldn’t the numbers be the same? The reason is those potential up or down swings. If you earn 100% one year (doubling your asset) and then you lose 50% the next year (reducing your asset by half), the average of that is 25%. If you are right back where you started, what good is an average return of 25 percent when your lived experience is 0 percent?
2. CAGR Reflects the Actual
As we’ve established, the CAGR reflects your actual rate of return over a given time period. However, instead of working from the individual ROR for each year, you’re working from the results of each year’s ROR to find what you’ve actually experienced. Calculating your ROR this way typically results in a lower number because it isn’t taking into account the ROR in particularly good and bad years, it only accounts for what has actually been earned.
Another way of explaining this is that the CAGR reflects the ROR you would have had to earn each year if every year was the same. So, to get from point A to point B, what would a continuous growth rate look like?
3. The More Volatile the Market, the Greater the Difference
When the market is volatile, the average rate of return can appear much more inflated, and in return, the CAGR may seem small in comparison. Brokers and advisors would much prefer to quote average rates of return, perhaps because the average rates of return are consistently more impressive than the Compound Annual Growth Rate, which is the actual rate of return.
Would you rather be quoted an average 25% return or an actual return of zero? With the former, you’d be led to believe that your account will be bigger by the end of your investment, and yet that just isn’t guaranteed.
How Volatility Erodes Market Returns – CAGR vs Average Growth Rate
The roller coaster ride of the stock market is what causes the actual rate of return, the CAGR, to be less than the average annual return quoted by planners and brokers. And that difference is what makes investors wonder, “Why isn’t there more money in my 401(k) if I’m earning X% interest? Why does it seem like I just have what I put INTO the account?”
The two factors that contribute to volatility are negative returns and the distribution of the returns. The more volatile an investment is, the lower the actual investment return will be. Any time you lose money, it takes an even greater return just to break even, let alone to get where you would have been if you earned a positive return in the first place. And the more you lose, the worse the situation gets.
It doesn’t even matter if the losses or gains come first. For example: If you start with $100,000 and you earn 50% in one year, you’ll have $150,000. But what happens if the market LOSES 50% the next year? Your investment drops to $75,000. Your annual average rate shows a 50% gain and a 50% loss, which makes the average annual rate of return 0%. Yet you didn’t end up where you started, you ended up LOSING 25% of your investment in 2 years! That’s a Compound Annual Growth Rate of -13.4, not 0%!
Reversing the order gives the same result. If you started with $100,000 and lost 50% in the first year, that would leave you with only $50,000. A 50% gain the following year would bring your $50,000 up only to $75,000 the second year. In either scenario comparing the CAGR vs average growth rate, the 0% average annual return resulted in a 25% loss or a CAGR of -13.4%.
Why the Distribution of Returns Matters
Now let’s look at how the distribution of returns affects the CAGR vs average growth rate. As you’ll see, you can have no negative years at all, yet still have a CAGR that falls below the average rate of return. As you’ll notice below in both examples, pulled from an InvestingAnswers article, as the distribution of returns gets larger, the compounded returns shrink.
In Scenario 1, you see the average annual return and the compound are both 10%, because there is no deviation. But in each successive scenario, the gap in the distribution of returns gets progressively larger as the compound annual portfolio returns shrink. Meanwhile, the average return is the same every year. It’s a technicality, and further proof that the average ROR doesn’t give you any tangible evidence of account performance. It’s ultimately just a fun fact that has nothing to do with your experience.
When negative returns are combined with a greater distribution of returns, average returns suffer even more. In the example below, the portfolio gained two years in a row, followed by a negative year. And as the scenarios progress, the good years get better while the bad year is even worse, with progressively disastrous results:
What does this mean if you are invested in the stock market? Historically, the market is either up or down by 15% or more about half of the time. This means that you should expect negative returns and a wide distribution of returns each year. In other words, don’t expect similarities when comparing the CAGR vs the average growth rate of a particular stock or mutual fund! And while this presents a challenge to be conquered for investors whose aim it is to “beat the market,” we see it as a challenge to be avoided if possible.
We don’t have a crystal ball, nor do we enjoy speculation, so we advocate for investments with predictable, reliable returns not subject to the roller coaster ride of the market. Even Warren Buffet, who popularized “Rule #1: Never Lose Money” lost a LOT of money in the Financial Crisis. And if the Sage from Omaha couldn’t protect himself from a catastrophic downturn, we won’t pretend to be wiser.
Guard Your Wealth Against Volatility
Then how can you guard your wealth against volatility? How can you achieve Compound Annual Rates of Return that resemble average annual rates of return?
For starters, STOP searching for “the next hot stock,” speculating with dollars you can’t afford to lose, and assuming that healthy returns and high risk go hand in hand. Next, consider the three strategies we like and use personally.
Build a Good Foundation
It’s so critical to build your financial future on a firm foundation. If you invest without it, your risk losing it all.
So what constitutes a firm foundation? Saving money is integral, and something many hopeful investors forget. Saving money has to happen independently of investing, so that you have an emergency/opportunity fund to fall back on. And in time, it can even become capital for future investments.
The hallmark of a good savings vehicle is certainty, liquidity, and guarantees. And that means whole life insurance. Whole life insurance is a powerful asset to save money into, and you can use the capital for any purpose at any time, while it continues to grow and compound. By building your financial foundation, you can whether financial storms no matter what is happening with your investments.
Look to Non-Correlated Assets
If the stock market is to be avoided, does that mean all investments are better off avoided? Not necessarily. There are many investment opportunities that have nothing to do with the stock market, and therefore have far less risk and lower volatility. These are called “non-correlated” assets, and are not subject to (stock) market crashes, interest rate fluctuations, or political unrest. Real estate, for example, is an extremely popular non-correlated asset.
Note that while these might not be correlated to the stock market, there are still risks in other markets. Be sure to do your due diligence before entering any deal, and be sure your properly understand the markets you invest in.
Diversify
To many investors, diversification is all about buying different stocks and bonds. Real diversification is having money in different markets (and of course, having some in NO market at all). By diversifying across different assets and markets, you can spread your risk. Prioritize cash flow so that you can continue to increase your income and your savings, as well as your asset base over time.
Finally, if you are invested in the stock market, don’t fall asleep at the wheel. Limit your risk exposure with strategies such as trailing stops and proper diversification.
Take the First Step With Us
The first step to protecting your dollars from volatility is to put them somewhere with certainty. At Prosperity Thinkers, we sell life insurance—the kind that can help you build a strong financial foundation that’s flexible and certain. Ready to find out how whole life insurance can improve your financial future? Book with us to get started today.
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