Do you know the difference between “Average Returns” and “Real Returns”?
Something that you probably won’t hear from many financial advisors (including your Wall Street commission broker who only offers you stocks, bonds, and mutual funds) is the difference between “Average Returns” and “Real Returns.” If you’ve never heard about this from your financial advisor, it could be time to question how much longer you will be employing them. Remember, your advisor should be working for you, which includes real education about financial topics as important as this.
I have taught educational classes at libraries and colleges and have asked the people attending how much money they can afford to lose in retirement due to investing. It’s almost always unanimous in that everyone answers “None,” “Zero,” “Nada.” They tell me they can’t afford to lose any money in retirement, but the vast majority have never heard about the important difference between average and real returns.
Let’s look at this simple hypothetical example: If you have $100,000 invested in the stock market, and it suffers a 50% loss and then a 50% gain, what is the value of your investment account?
The majority of people answer that they still have $100,000 in their account. This sounds logical — especially since the investment account statements that you receive in the mail every month or quarter show the average rate of return. But let’s do some quick math:
- $100,000 suffers a 50% loss – the investment account is at $50,000.
- $50,000 gains 50% – the investment account is up to $75,000.
In this hypothetical example, the “average return” is 0%. But the “real return” is minus 25%. Quite a big difference.
Wall Street typically does not talk about this. The so-called investment gurus on television do not talk about this. Your long-time financial advisor most likely has not told you about this. I don’t think this is taught in business classes at many colleges.
Any time that you suffer a loss in an investment account during a period of time, the average return will be lower than the real return. This kind of makes you wonder why the brokerage firms do not report what the real return percentages are on the account statement, instead of the averages.
Let’s reverse the order in this hypothetical example: $100,000 gains 50%, so the account balance is $150,000. It then loses 50%, so it’s down to $75,000. The order of gains or losses does not matter in this example.
Even with smaller losses, there is still an impact. $100,000 that suffers a 10% loss will take the account down to $90,000. Then a 10% gain on this account only brings it back to $99,000. Every time, without fail, that there is any kind of loss over a period of time, there is a greater gain needed just to get back to even. Keep this in mind: The larger the loss, the greater the gain that is needed.
- 10% loss requires an 11% gain to get back to even
- 20% loss requires a 25% gain to get back to even
- 30% loss requires a 43% gain to get back to even
- 40% loss requires a 67% gain to get back to even
- 50% loss requires a 100% gain to get back to even
- 60% loss requires a 150% gain to get back to even
Now, let’s look at an example where you actually have a positive average return, but can still lose money because the real return is negative: $100,000 that loses 40% is down to $60,000. If this gains 50%, then the account is only back to $90,000. In this example, the average return is positive 10%. The real return is minus 10% because you would have a $10,000 loss. This is how you can see a positive average return on your investment account statement over the course of time but still see your account balance going down — or not gaining as much as it should be.
In retirement, it’s vital to have the proper amount of your hard-earned money invested in the proper places. This should be based on your unique situation and goals. It should not be based on the product-based, cookie-cutter investments that a number of the large brokerage firms push on their clients. When I have a meeting with a person for the first time, I can often predict which investments they have when they tell me which firm they have their investments with. It’s usually the same mutual funds that everyone else has that benefit the investment firm and not always the clients (which is you).
I am securities licensed and feel very good about the investment company that I represent, which is different than what the big brokerage firms offer. Many of my clients have stock market investments along with investments in places outside of the stock market. It’s about having the proper “balance” of investments based on your best interests while always keeping in mind that any kind of investment loss will require a greater gain just to break even.
This is why my firm will do a comprehensive portfolio review in which we will look at the returns over the course of 1, 3, 5, and 10 years, along with risks, fees, and other factors. We’ll then compare this to investing in low-cost index funds. Next, we’ll look at different options to see what the impact from some simple changes and improvements could be. Improving your investment returns by just a little while reducing the risks and fees could have a huge positive impact over the course of the next 5, 10, and 20 years. When your downside exposure is reduced along with the fees you are paying, this adds up. Compound this over time, and it results in a difference of hundreds of thousands of dollars or more for some clients.
The whole point of this article is to educate you about the difference between average returns and real returns. If you are 65 years old and have never heard this, you might be asking yourself what else there is that you haven’t been told about. If you have a financial advisor, it could be time to start thinking about other options, such as a new advisor. If you have been going it alone, doing your own investing, and didn’t know about this, then it could be time to consider using the services of a financial professional to help ensure your retirement goals stay on track.
It’s your hard-earned money and financial future, which is best not left to chance. You deserve to have the added peace of mind that can come from having a real plan — which accounts for various things, including real returns. We will leave the average returns to Wall Street and the average investor.
For more information or to schedule a meeting, please contact our office.