Rate of Return and Investing - Losing your Shirt!

Understanding the actual rate of return on your investments or in the stock market is an important first step towards building riches - and the first step towards that is understanding average versus compounded rate of return.

And the reason understanding that difference is crucial is because losses and volatility will destroy your real rate of return. Hence, as a maxim:

Avoid Losses!

Hey that works! And so simple. If I simply do not lose any money, then I will make money or at least stand pat!

Well, there is a stronger reason to avoid losses, or to even avoid low return years - and that is because those years will seriously eat into your overall portfolio returns measured across multiple years. Negative years in the stock market as well as high volatility in the markets (i.e. markets returning 20% one year and 1% the next) directly bite into your overall returns. You should aim for consistent returns.

For example, a market that returns:

10% in year 1
-5% in year 2
20% in year 3

will, at the end of year 3, take $100 to $125.40.

However, the average return for the three years is 8.33% (10 -5 + 20 / 3).

If you simply told someone that the market averaged 8.33% over the last three years, they would assume that $100 invested would have actually made $127.12 and not $125.40!

This is because they assumed that your money compounded by 8.33% every year. But it did not!

Your compounded average was unfortunately much lower at 7.8%!

Compounded average is the real average that an investor has to deal with. One can claim that the stock market in its last 100 years has averaged nearly 11%, but what was the compounded average? This average was unfortunately a lower number owing to stock market volatility over the years.

Folks at Crestmont Research (www.crestmontresearch.com) have done a superb job of calculating and presenting this information for you. Take a look at the figure below for 10 year intervals for stock market returns. You will see that the average return is around 7.3% while the compounded rate of return was only 4.9%! That is a sharp difference in the overall rate of return.

Crestmont Research also presents several parallel examples of how different returns affect the average and compounded results. This figure is shown below:

Study each of the cases above carefully and see how the compound rate of return tends to track below the average rate of return the moment any form of volatility enters the picture. Volatility may be the friend of the trader - but it is the enemy of the buy & hold investor.

This should leave you with the overall idea that you should always ask for the compounded rate of return and not the average rate of return, which is misleading and discounts the very real effects of volatility in returns and the devastating effect of negative return years.