Anyone whose portfolio has kept them up at three in the morning knows a little something about infomercials, a harmless enough way to spend a few sleepless hours as long as you remember the hard and fast rule to never actually buy the products. It doesn’t take very long to figure out that there is always somebody willing to sell you something. And Wall Street is no different.
Wall Street has a dirty little secret and they are doing their best to keep it that way. It is standard practice that whenever mutual fund companies promote their returns over the last 3, 5, and 10-year periods they use average rate of return as the performance indicator. We have seen it presented this way for so long that we don’t even think twice about it. The problem with using this as a performance measure is that the average rate of return does not accurately reflect how much your money actually grows. It actually overstates the actual return on your investment, which is deceptive and leads to disappointment down the road.
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Whenever we meet with a potential client, a familiar conversation usually occurs. As we review their portfolio, we ask why they picked certain investments. More often than not the client answers that their advisor showed them the performance history and it looked like a good investment. We then ask them the following question: “Your investments say you had an average return of x%, do you feel like your money grew by that much?” Most clients think for a moment and then respond, “No, it seems like it grew less than that.” If you’ve had the same thought, we are here to tell you: You are not alone. We’re all being duped by Wall Street’s marketing machine.
A simple example will show you why. When average return is calculated, all returns, whether they are gains or losses, are given equal weight. In other words, a 10% return followed by a 10% loss produces an average return of 0%. Pretty simple, right? Using this calculation, you would assume that if you invested $10,000 at the end of the ten years, you would still have $10,000.
The Dirty Little Secret
The dirty little secret is that this is not the case. If you do these calculations using the actual numbers, you will find that after the first year your investment has grown to $11,000. After calculating the 10% loss the following year, your investment is not worth $10,000 but instead is worth $9,900. When this is illustrated over a 10- year period, the “actual return” is quite different from the average return you used to choose the investment and reveals what Wall Street has been hiding. Rather than producing $10,000, your 0% rate of return has netted a return of just over $9,500. In other words, your “0%” average rate of return reduced your investment by nearly 5%.
To put this another way, from 2002 to 2012 the S&P 500 produced an average rate of return of 3.058%, but during this same period of time the actual return was only 1.02%.
You may be thinking, “Big deal. Two percent doesn’t make that much of a difference.” If you used the average rate of return to calculate your return on an investment of $100,000, you would assume that your account is now worth $135,150 when in reality it only grew to $110,249, a difference of almost $25,000.
Average and actual returns will always be the same until there is a negative day, month, or year in the market. Once one negative return creeps into your portfolio, the two returns part ways and it is mathematically impossible for them to ever equal each other again. At this point, you will always earn less than the average rate of return. Did you hear that? It only takes one negative return and your investment will underperform the “average” return you used to choose the investment.
Negatives Returns Sure Are Heavy
When we meet with a client for the first time, we walk through a basic illustration to demonstrate the impact of losses on a portfolio. We will write down $100 on a sheet of paper and then ask, “If we invest this money and lose 30%, how much do we have?” The client quickly answers, “$70.” We then ask, “So how much do we have if it then grows 30%?” Many clients quickly answer, without giving it much thought, “$100, of course.” We quickly ask, “Are you sure?” After taking a second look they realize that a 30% return on $70 only gives you $91 and the light bulb begins to come on. We then show them that it actually takes a 43% return to overcome a 30% loss.
The fact is, if our portfolios include negative returns, it will devastate the actual return we get on our money. The scary part is that it only takes one year of losses to wipe out several years of gains because of how much weight the negative returns count against your total return.
Avoiding The Marketing Land Mines
Now that you know how investments are being marketed, you can navigate the land mines that are being set all around you and choose the right investments. The key is to evaluate the performance of the investment using the actual returns so that you will be able to differentiate the winners from the losers. As you choose investments with lower volatility and identify options with limited or zero losses, the expected return and actual return will be much closer and the performance of your overall plan much more consistent. Implementing this simple change will reduce those sleepless nights and is a critical step to insuring the success of your financial plan.