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Why Your Average Rate of Return Is Misleading

Michael Hicks

In 1914 at the start of World War I, none of the combatants provided steel helmets to their military soldiers. As the war went on, a steel combat helmet, known as the Brodie helmet, was introduced in London one year later.

This was an incredible upgrade from the previous models made of cloth, leather, or felt. It effectively lowered fatalities immediately after its introduction to the war.

However, after the Brodie helmet was introduced, military authorities and the war office became increasingly alarmed to discover that there had been a substantial increase in head injuries with soldiers.

The question quickly became, “Why would there be an increase in injuries after implementing a safer, bullet-deflecting piece of combat equipment?”

At first glance, this data appears to make no sense. One might even be inclined to revert to the cloth helmets again.

But this data was misleading.

When examined closer, it was found that the reason for the increase in head injuries was because, instead of being killed in action due to lack of protection, soldiers were suffering from gunfire and shrapnel striking their helmets.

There are misleading statistics in just about every field. It takes a discernible interpreter to sift through the easy misinterpretations.

For instance, a surgeon with a higher patient mortality rate doesn’t necessarily mean they’re a bad surgeon; it could mean they specialize in extremely difficult and dangerous surgical procedures.

Misleading Rates of Return

When it comes to your investment statements, one of the most misleading metrics is the average rate of return.

Fund managers, account statements, the media, and marketing literature advertise average rates of return as a way to encourage people to invest in certain products.

While average rates of return can be a relevant statistic in some cases, they are not useful with investments that experience performance loss and negative years in the market.

In fact, in some cases, an investment with a higher average rate of return can underperform another investment with a lower average rate of return.

Let’s look at an example.

In the below illustration, we look at an investment vehicle that is 100% invested in an S&P ETF. The initial investment is $100,000. The S&P ETF participates 100% in both the growth and loss of the index. The average rate of return for this period was 7.03%.

At the end of 18 years, $100,000 grew to $257,784 with an average rate of return of 7.03%. There were some negative years at the start with the dot-com bubble and in 2008 with the housing bubble crash, but there were also some good years beginning in 2009.

Let’s add in the second investment vehicle for comparison. This vehicle gets only half the growth the S&P experienced, but it avoids the losses altogether. With only participating 50% and removing the negative years, the average return comes back at 5.70%. Not too bad, but not as great of a return as the S&P ETF we previously discussed.

However, when you apply those performance numbers to the $100,000, you can see that the second vehicle outperformed the first by $9,553 with a final dollar amount of $267,337. Even though the average return was 1.33% lower, the account balance was higher in the end.

Average returns needlessly focus on the incremental changes between years, losing sight of the big picture and what’s relevant.

Real Rate of Return

A much more useful measurement would be to calculate the real rate of return. Real return is where you look at the starting and ending value of the account.

In one final example, let’s look at the below chart where we can compare the average return to the real return to see how different these data can be.

There is a real disparity between average return and real return, largely due to the impact of losses. The real return is what matters and, as you can see in our prior examples, it’s not always on the frontline.

Bottom Line

When a fund manager, statement, or piece of marketing literature can stack the deck in their favor with a more attractive-appearing statistic (such as a higher average return percentage), it is likely to be the featured information to distract from other, potentially ugly, information.

Are you being misled by your investments? We’d love to help you review your accounts and uncover your real rates of return.

Click here to get in touch.

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