Investing is all about benchmarks. To understand the success of a given investing strategy, you need to understand the most common metrics used in analysis and reports. Average returns and actual returns are two of the most common.
What is an Average Return?
Average returns are generally annual returns that are averaged out over a period of time. As an example, there may be an average return that is averaged over the past ten years. Average returns can tell an individual how an investment such as a mutual fund performs over a given period of time.
Consider that the stock market has consistently risen over 20 years, but may dramatically rise or fall during a single year. The average return for the last 20 years will tell an investor that the stock market generally goes up, but it may not say anything about the volatility of the market during that time.
For an average return to be as relevant as possible, you need to be aware of the time period that the averages are taken from. You also need to be aware of the inherent volatility within the investment, because this could impact your risk profile.
Here's an example of average return:
Year 1: 5% gain
Year 2: 10% gain
Year 3: 15% gain
Average over 3 years: 10%.
But though this may seem straightforward, it actually has some significant flaws compared to an actual rate of return. A 5%, 10%, or 15% gain is relative to the amount that has remained invested at the beginning of the year, and consequently each subsequent year's actual gains and losses is impacted by the gains and losses of the previous year.
What is an Actual Rate of Return?
An actual rate of return isn't how much the investor "actually" makes compared to the "expected" return. Rather, the "actual rate of return" is a different way of calculating averages. It's best understood using an example.
If an investor invests $100,000 and gains 10% one year and -10% the next year, their "average rate of return" is going to be 0%. They gained 10% then lost 10%, so that nets to 0%. You would then expect the investor starts and ends with $100,000 (since there's a 0% return), but that's not true.
That's because if an investor invests $100,000 and gains 10%, they have made $110,000. If they then lose 10% of $110,000, they are losing $11,000, not $10,000. They end their second year at $99,000 rather than $100,000, and the actual rate of return is -1% rather than 0%.
Thus, the actual rate of return is actually far more accurate, because it takes into account the fact that you're gaining and losing money at different rates.
|Year||Beginning Acc. Value||Earning Rate||Interest Earnings|
|Average Rate of Return: 0%||Actual Rate of Return: -1%|
Which is More Important?
The actual rate of return is almost universally more accurate for an investor's calculations. At the same time, general average returns can be useful for comparing different types of investments, relative to each other. They can give an individual a general picture of the investment's performance, as well as whether that performance is rising and falling (by comparing different time periods).
When an investor is choosing an investment, however, they should be aware that the average rate of return may be misleading compared to the actual rate of return. For most purposes, the actual rate of return is the number that an investor will want to consider.
So why are average returns so much more common? Average returns tend to be promoted by investment companies because they are usually higher than the actual rates of return. This can give an investment the illusion of being more profitable than it really is.
The average return and actual return metrics underscore the importance for you to gain an in-depth understanding of your retirement portfolio. Without an understanding between average returns and actual returns, you may not understand the potential risks associated with your investments.
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