Monday, October 3, 2011

Financial FICTION #10: If the stock market has averaged "x" percent return over a given time period, you'd have earned that return too

Financial FICTION #10: Learning that the stock market or a specific variable investment has averaged "x" percent return over a given time period means that if you had owned the same investment over the same time period, you’d have earned that return in reality.


The investing public is bombarded with "average return" information about specific funds over such-and-such periods of time. If you look at your mutual fund or 401(k) statement, you will see this information being advertised when the market is doing really well, or simply reported as required by law when things are not going that great.


The question is: What do those average return numbers mean to you? Does it mean that’s how much your investments made over the same period of time? Does it mean that if you don’t own that investment yet, that’s what you would have made if you had owned it? Think again, because it’s not even close!


Here’s what’s actually going on in nine of 10 such situations: those average returns that are being advertised are the simple average or arithmetic mean. But in investing, that average is bogus because that’s not how money grows. Instead, what you need to know is the real annualized return, also known as the compound return.


If you were to take any of those simple average numbers being advertised and do the math, you’d never even come close to the actual money in your account. Let me illustrate with this example: Over the past 10 years (from January 1, 2001 through December 31, 2010) the S&P 500 has averaged 3.55 percent. Which means (or is supposed to mean) that if you had placed your money in this investment, you’d have earned that “average” return.


Let’s say you had invested $100,000. So, at a 3.55 percent average per year over the past 10 years, you’d have had $141,743 in your account on December 31, 2010. Here’s the shocker, though: That’s a complete myth – one of those things that seems right but couldn’t be further from it.


In actuality, your $100,000 investment would have been worth $113,900, a whopping $27,843 less than the number we just figured should be the average return. I don’t know about you, but most folks who are caring for their families and focused on their careers probably would not appreciate any half-baked distortions that could cause them to improperly calculate their future income. The distortion arises because over that 10-year period, the actual compounded return of the S&P 500 (which, by the way, is how investment accounts grow) was 1.31 percent – that’s a 20 percent deviation from the 3.55 simple average – and used in 99.99 percent of cases.


Mathematically, compounded average is calculated quite differently than simple average/arithmetic mean. This is a classic case of not all averages being the same. And although those advertisers and advisors know full well the difference between the two, they choose to quote “simple averages” instead of “compound,” presumably because the numbers look more enticing. Talk about fiction versus fact for a moment. They may both be averages, but in reality, their results are very different.
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Call a financial professional at Laser Financial Group today to set up your complimentary, no-obligation consultation. They'll walk you through the complexities of compound interest, and look at your goals and current situation to help you determine the best path for your future. 877.656.9111 or LaserFG.com.

2 comments:

  1. Great information...Thank you!

    ReplyDelete
  2. A Ntsifuah,

    Thank you for reading and for your kind words.

    ReplyDelete

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