CFP®, RFC, CSA
Senior Financial Advisor
Understand the Difference between Average Annual Returns and Compound Average Annual Returns.
A common mistake investors make is assuming a certain rate of return and the impact it has on their portfolio growth. This is illustrated with the chart below:
Upon review, what you'll notice is the effect volatility has on investment returns. In case A and case F the simple average return is 5% (the simple average return is the sum of three years divided by 3). However, the compound rate of return in case (A) is more than double that of case (F)
Let me use another example. Assume that in the beginning of year 1 you invest $100,000, and that year your investment has a 50% loss. Losing 50% of $100,000 would leave you with $50,000 in your investment account at the end of year 1. In year 2 your investment has a 50% gain. That's great news! You are back to where you started, right? Unfortunately not. At the end of year 2 your investment account would have a value of $75,000. The simple rate of return on this investment would be 0% which would lead many investors to believe they would be back to where they started, however, in reality the compound rate would be -25%, and a loss of $25,000.
Because many investment rates of return are calculated on a simple average basis, investors are often over confident in what their portfolio will grow to. Most retirement planning software programs used by financial planners work on this premise; i.e. a simple average return is assumed in the calculation of the growth of a portfolio. Big mistake!
If you don't know what the actual compound rate of return is of your investments, or if you are assuming a high rate of return (perhaps 10% or greater), you are not taking into account the affect volatility of returns will have on the actual growth rate of your investments.
This is the argument for asset class diversification and one of the many reasons high net worth investors utilize alternate asset classes in their portfolios - to attempt to grow assets in as consistent fashion as possible.
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