BLOGS

The Fuzzy Math of Average Returns

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Have you ever seen an illusion that baffled your mind and you wondered "Wow! How did they do that?"

Magic or illusions are great entertainment and when it comes to building your wealth or securing your retirement, it's not fun anymore.

The financial services industry has been performing a grand illusion when it comes to choosing an investment or evaluating if your investment has been performing. I want you to think back to a time when you went on line or opened your statement up for your accounts to see how they have been performing.

Have you ever noticed that the stock market keeps going up and your account barely moves? Your financial adviser told you that your account averaged X percent and you don’t see that X percent in it.

Well if you have noticed that, that's the illusion the industry has been using for years to confuse the average investor.

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As you know in language, the words you learn and use defines your reality. When you want to keep someone in the dark, you use language that people don’t understand.

The financial services industry has been using this type confusing language for years on investors.

The language is like a misdirection or an illusion in a magic show.

What I’m about to share with you is two words that people put the most faith in when evaluating performance and choosing an investment that seems simple and straightforward but when you pull back the curtain you will see the “Magical Illusion.”

The two words are “Average Returns.” Most people have heard of average returns and on the surface and it seems like a good thing.

But there is one word that the average investor doesn’t really understand or focus on. That word is “Yield” and this word makes a difference if you are getting ahead or not, when it comes to your investment results.

Did you know that you can have the same the average return and get three different yields? Another word for yield is “Actual Return.”

I’m going to show you three examples below, which shows the same the average return and it has three different yields.

Example 1 – Positive Yield / Actual Return

Year

Return (%)

Ending Balance ($)

0

0

$100,000

1

10%

$110,000

2

10%

$121,000

3

10%

$133,000

4

10%

$146,000

Average Return: +10%

Yield or Actual Return: $46,410

In this example, you can see your average return is 10%, your periods have all positive returns, and your ending balance is up over $46 thousand dollars. You’re very happy.

Example 2 – Zero Yield / Actual Return

Year

Return (%)

Ending Balance ($)

0

0

$100,000

1

58%

$158,100

2

-37%

$100,000

3

54%

$153,505

4

-35%

$100,000

Average Return: +10%

Yield or Actual Return: $0

In this example, you can see your average return is 10%, you have two periods of positive returns, two periods of negative returns, and your ending balance is what you initially started with.

Example 3 – Negative Yield / Actual Return

Year

Return (%)

Ending Balance ($)

0

0

$100,000

1

150%

$250,000

2

-20%

$200,000

3

-25%

$150,000

4

-65%

$52,500

Average Return: +10%

Yield or Actual Return: $-47,500

In this example, you can see your average return is 10%, and at the end of year 1, your ending balance is up $150 thousand dollars. The following three years are all negative and you end up with an ending balance $47,500 less than the initial investment amount you started with.

As you can see from the examples above, over time, you can have the same average return and the actual amount you receive in your account is significantly different and this doesn't include fees that the financial institutions, stock brokers, mutual funds, and investment bankers charge you a fee whether you make money or not or taxes.

This is the smoke and mirror advertising that the financial institutions use to keep you primarily focused on stock market strategies and not on other alternatives that are more predictable that don’t have the up and down volatile stock market swings.

They want to keep you comfortable as you invest your money in the stock market.

So, the next time you hear or see the terms “Average Return”, you know the whole truth on what’s behind the curtain, and you know now how the "Magical Illusion" works.