Why are Oft-Touted Average Returns Deceptive?

Average returns are often touted in the investing world. But quoted AVERAGE RETURNS DON’T TELL THE WHOLE STORY.

In columns B and C, the table below considers an investment of $100,000, PLACED INTO THE S&P 500 INDEX of the 500 largest American companies at the start of 1999. Twenty-four years later, as of December 31, 2022, THE BALANCE HAS GROWN TO $312,323, EQUATING TO AN AVERAGE ANNUAL RETURN OF 5.90%. Considering this period contained three stock market crashes, a financial crisis, and a global pandemic, that’s not exactly a shabby annual rate of return!

Now take a look at columns D and E, which contain annual return percentages and dollar values for a hypothetical investment that EXACTLY TRACKS THE PERFORMANCE OF THE S&P 500 but is CAPPED AT RETURNS OF JUST 9% ANNUALLY (no matter how well the S&P 500 actually performs) and GUARANTEES NO LOSS. In other words, for this investment, annual returns will always fall somewhere between the floor of 0% and the cap of 9%. For this strategy, you’ll notice that the AVERAGE ANNUAL RETURN IS LOWER than our pure S&P 500 investment, at ONLY 5.37%

An Average Return of 5.90% should yield a higher ending cash balance than an Average Return of 5.37%, right? It’s a higher return, after all!

Alas, THIS IS NOT THE CASE, as a comparison of columns C and E reveal. In fact, our hypothetical investment in which RETURNS MAY ONLY RANGE BETWEEN 0% AND 9% in the end gives us OVER $43,000 MORE IN REAL DOLLAR TERMS than the uncapped strategy that follows S&P 500 returns (both positive and negative) exactly.

Looking again at our table above, we see the ACTUAL ANNUAL RETURN (also called the COMPOUND ANNUAL GROWTH RATE) is HIGHER for our 0%-9% strategy represented in columns D and E than it is for our “uncapped/unlimited” strategy represented in columns B and C.

But why is this the case?

Simply, this is because AVERAGE RETURNS DO NOT TAKE INTO ACCOUNT THE GAINS THAT ARE REQUIRED TO RECOVER FROM A LOSS.​

Looking at the table above, we can see A LOSS OF 10% REQUIRES AN 11% GAIN to return to our original balance. Likewise, A LOSS OF 40% (which is approximately what S&P 500 investors suffered in 2008) actually REQUIRES A GAIN OF 67% to return to our original balance. And on and on - to the point that A 90% LOSS REQUIRES A 900% GAIN just to get back to our original balance. ​ASTOUNDING!

So, tying this all together…what does it mean? Here is what we conclude:

1. You should pay attention to more than simply the average annual rate of return as you compare different investment options. It is important to understand how each investment actually works so you can instead calculate and compare the Actual Annual Return, or Compound Annual Growth Rate.
2. The S&P 500 and other indexes do indeed return on average north of 8% over the long term (as is often the case when looking at periods measuring 30+ years in length); however, average returns do not equate to actual returns so considering a starting amount of any value and increasing it by 8% annually over some period of years to project an ending balance will not give an accurate assessment of performance.
3. It is important to consider the price at which you are entering an investment as this can greatly impact your real returns over the long term.
4. Most important of all, the idea of never losing money on your investments is invaluable, as this will always enhance your real cash returns by a wide margin and make a bigger difference in your long-term returns than any other single factor.

If we could show you options for growing your cash value that are guaranteed not to lose money and are capped at annual rates of return between 9% and 11%, would you be interested in learning more? If so, please use the Contact us link in the navigation menu to schedule your complimentary and fully-customized financial consultation with one of our team members today.