Bank Insurance hipopnews January 6, 2024 0 Comments

Everything Regarding Rate of Return You’ve Always Wanted to Know

To be quite honest, writing this piece is making me feel a little bit like the character played by Jack Nicholson in the film “A Few Good Men.” Do you recall the sequence in the movie that stands out the most, where Tom Cruise is questioning Nicholson and asking him to tell the truth?

“You can’t handle the truth,” Nicholson responds.

What on earth is that related to figuring out compound annual growth rates, then?

One of the biggest secrets in the investment industry, however, is that average return figures are very misleadingly advertised by mutual funds, variable annuities, and a host of other products that are dependent on the performance of the stock market.

2 + 2 = 4 …. Except on Wall Street.

The investment industry would have you believe otherwise, but the truth is that this problem is straightforward and requires only simple maths.

The compound annual growth rate (CAGR) is the only return that matters, and the average annual return, as it is always stated in investment literature (marketing pieces, prospectuses, etc.), is just a purposeful shell game designed to cloud your perception of the returns by stating basic arithmetic mean calculations.

I know it seems like I’m picking at straws, but bear with me while I give you an example so you can see why I’m upset.

As an illustration, let’s say Bill invests $100,000 in his J.T. Marlin investment account (some of you may recognise the Boiler Room allusion). In the first year, the account grows by 25%, but in the second year, the account returns a negative 25%.

Stock market ninnies would claim that your average return is zero percent.and they would be speaking the reality.in the same conceit with which President Clinton maintained he had no sexual relations with her.

However, they are distorting the facts by using absurdity, as it is irrelevant to them.

First year: 100,000 x 25% = 125,000

After two years, 125,000 x (-25%) = 93,750

At the conclusion of the second year, Bill’s account is worth $93,750; hence, his actual compound annual growth rate (cagr) was -6.25%. Bill started with $100,000.

However, I have demonstrated in the example that his yearly rate of return was 0% on average.

How therefore may Bill’s wealth have decreased from where it began?

Greetings from Wall Street’s Imagineers and the Wonderful World of Investments.

I’m really at a loss for words.

It’s clear that the Enron accountants have settled down on Wall Street and are deeply entrenched in producing news for the financial media.

I respectfully disagree with Investopedia.

The only kind of return that matters at all is your actual return. Telling Bill (see above) that his account averaged 0% for the last two years is fictional!

utterly crazy.

What I “averaged” over the previous two years doesn’t matter. It is not a zero-sum game if my starting bankroll is smaller than it was at the beginning.

If you were to have that conversation anywhere other than Wall Street, you would be killed.

Why then does the investing community always cite average return figures?

You have a minute to work that one out on your own, I promise.

since real returns always seem better than average annual returns.

Visit moneychimp.com to see a useful tool that allows you to view the figures as they actually are. You can experiment with various time intervals, account for inflation, and so on.

I’ve included a few screenshots to give you a quick overview of the differences between the average annual return and the actual return (cagr) during the previous 10, 15, and 20 years.

The fact that there have been times in the market when the “average return” is positive but the real return on your investment was negative makes the average return so deceptive.

What’s the average, does it matter?

That’s analogous to discussing the gross income of a business.

The only figure that counts if you hold stock in XYZ Corporation is net profit. What difference does it make if the company made $1.25 per share but its net profit to shareholders was only one penny?

Remember what Buffet is stating in this quote; it holds true in this situation.

Naturally, keep in mind that I haven’t even taken into account how inflation affects the returns. This is another fantastic feature of the moneychimp website—you can add the return figures that have been corrected for inflation.

It is evident that inflation reduces returns with respect to both average and actual numbers. That should come as no surprise.

The truly awful thing about this whole scenario, in my opinion, is that most of the people who spread this misinformation are unaware that they are acting improperly! It’s so ingrained in the calculations to ignore compound annual growth rates that counsellors, CFPs, investment advisers, and other financial professionals just rattle off the statistics without raising an eyebrow.

While I can’t say that they are purposefully lying, I can say that the majority are simply unaware of the truth.

And which is worse, I’m not sure.

Ask lots of questions and do the maths yourself, is my advise. It’s only at that point that you’ll know you made the right choice.