Whenever the media discusses a market index’s return, or when mutual fund companies promote their returns over the last 3, 5, and 10-year periods, they always reference the Average Rate of Return.
The average rate of return has been accepted as the standard in today’s world and nobody even bats an eye at it. Even when I help people plan for retirement or when I’ve discussed an investing post on this blog, I always calculate things based on the average rate of return. For instance, if you invest $500/month for the next 25 years, and assuming you earn an 8% average return, you should be able to retire with no problem.
However, have you ever been one of those people that have said: ‘I know they claim the S&P 500 has AVERAGED 14% over the last 3 years (true story), but I haven’t gotten anywhere close to that! I’ve only made 10% even though I’m in a S&P 500 Index Fund!’?
If you’re one of those people that have wondered why you never get the same returns that people claim the market is averaging, then I’m happy to tell you that you’re not crazy!
To get my point across, lets play a game today! No trick questions by the way.
So, based on the chart below, what is the Average Rate of Return?
The average rate of return is 0%, right? 5 years of +10% gains and 5 years of -10% gains would come out to a 0% average rate of return.
Now, let’s take this a bit further…
Let’s assume that you invest $1,000 and the exact same scenario takes place: up 10%, down 10%, up 10%, down 10%…and so on for 10 years total. Who out there believes that you’ll still have $1,000 left in your investment account after the 10-year period? This blog thing really isn’t a good medium to ask questions…dang.
Do the math, it’s quite fun:
Well, the truth is that you will only have $951 left in your account! Good for a -4.9% Actual Rate of Return.
As we can all see from the example above: it is mathematically IMPOSSIBLE for you to realize the average return if there is ever a negative day, month, or year in the market.
This holds true for returns on precious metals, returns on individual stocks, and especially returns on mutual funds. The average rate of return isn’t really what you earn, so stop paying attention to it!
Just to make my final point: the S&P 500 averaged a 2.11% rate of return for the year of 2011. However, if you were to have invested $1,000 on January 3, 2011 (the first day the market was open last year) and pulled your money out of the market on December 30, 2011, you would have made a whopping $3.55. Also good for a .355% Actual, Realized Return.
A 2.11% average and a .355% actual return are quite different. The statistics say there there is about a 1-2% difference in the average returns that the media/mutual fund companies promote and what you realize as your true return.
Has it ever occurred to you that you’re not earning the “average” rate of return? Do you think it’s wrong that mutual fund companies and the media promote average rates of return?
Editor’s note: I don’t believe promoting the average is wrong or misleading. The numbers they promote are truly the average; we just haven’t been savvy enough to know there is a difference between the average and actual. It’s like understanding the difference between median, mode, and mean.
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