The Folly of Chasing Returns (Part 3)

The Folly of Chasing Returns (Part 3)

 Let’s say that you were looking to invest $10,000 for 3 years and were presented with these two options:

	Option A	Option B
Year 1	+ 10%	+3%
Year 2	+ 10%	+3%
Year 3	- 10%	+3%
Total	+10%	+9%
Simple Average	+3.3	+3

The obvious question here is: Given the above information and holding everything else constant, which option would you, or more appropriately should you, choose? Pretty simple, right? If I were to guess, I’d bet more likely than not you would go with Option A. After all A’s total return over the 3 years is 10 percent, compared to B’s 9 percent. Also, A’s simple average is 3.3 versus B’s 3 percent.

However, Option B is the much better option than A. YES, really! At the end of the three years, you’d end up with more money if you went with Option B. Money math is a whole different ballgame altogether, isn’t it?

Before we go any further, know that if you thought Option A was better than B, your choice corresponds with the overwhelming majority of folks to whom I’ve posed this question. And I totally understand that choice – but the thing is, money math works differently. Here’s how the math works out.

Option A: the initial $10,000 grows by 10% ($1,000) to $11,000 at the end of year 1. The $11,000 grew by another 10% ($1,100) to end year 2 at $12,100. In year 3, it lost 10% of the $12,100 ($1,210) so the ending amount was $10,890.

Option B: the first year’s interest would be $300 (3% of the initial $10,000) for a year-end balance of $10,300. In year 2 that $10,300 would grow by another 3% ($309), increasing to $10,609, which would then grow by another 3% ($318) to end year 3 with a value of $10,927.

Now it’s crystal clear that Option B would return the most money: $10,927 versus A’s $10,890. Who would have thought that? You see the one thing that a lot of retirement investors seem to lose sight of (and I’m not blaming them as much as I’m faulting their so-called financial advisors) is the consistency of returns. Sure, Option A seemed to have the “higher” interest numbers, but how consistent is or would that return be?

If there’s one thing I hope I’ve effectively communicated to you in this three part series, it is that you understand that things aren’t as obvious as they may seem or made out to be when it comes to interest rates. My sincere hope is that you are connected with a savvy advisor who takes these necessary aspects into consideration before making the critical choices necessary to ensuring you get the most out of your hard-earned money.
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