Does market volatility leave you confused when trying to calculate your annual investment returns? Or, is a flashy piece of marketing making it hard to calculate the actual gain you can expect? Investment products and marketing can confuse even the simplest concept, so read on…
By learning the difference between an Average Rate of Return and the Internal Rate of Return (Or Effective Rate), you will begin to understand how increased volatility can decrease your real investment return… no matter what the ads and past performance milestones tell you.
Which 10% do you want?
Seems like a silly question, right? It’s not- what we’ll demonstrate below is critical to measuring different investments.
But it’s important you read this whole post- the key point comes near the end (spoiler alert!)
Often you’ll see a mutual fund or other investment advertising its 1, 5 and 10 year historical rates of return. The first thing to be aware of is that taxes are almost never factored in here, so take this return number with a big dose of salt.
The next concern we have with this return representation is the method of calculation. Too often, you’ll read in the disclaimer or disclosure statement that the manager uses an Average Rate of Return rather than an Internal Rate of Return. This masks volatility and can be highly deceptive.
The answer to ‘Which 10% Do You Want?’ comes down to how well you know the difference between these two measures of investment performance. Understanding this will shed light on what I consider to be misinformation and possibly deceptive marketing by many well-known money managers.
The Internal Rate of Return is truly a discount rate at which the present value of the investment plus all the future cash flows equals $0. In other words, a true ‘discounted cash flow’ measure.
This is a longer term, true measure of return for a variety of cash flows and is equivalent to the ‘Yield to Surrender’ in Annuity products. It is also the “Effective Rate” that we use to measure performance in Secondary Market Annuities.
The Average Annual Rate of Return is simply an average of the year-end rates of return. So, adding the percentage returns from each individual year and dividing by the number of years will give you the arithmetic average.
Many investments, mutual funds, and indexes may be reported using this method. (In the fine print!)
When a constant yield is used to illustrate an investment return, the Average and the Internal Rates are identical. But when returns differ from year to year (as they always do in real- life investments) the two ways of measuring can be very different, and the effect on your portfolio is also drastic.
The key lesson- Volatility can destroy an account value but investment managers can calculate their returns in a rosy way that is technically correct, but that leaves you with less money.
Let’s keep this exercise simple to illustrate the point.
So, consider an initial $100,000 investment and analyze the dollar value of that after a two-year period under several return scenarios that all yield a 10% average.
We’re going to assume you leave your money invested over the 2 years and look only at what you went in with and what you came out with.
Scenario 1 shows an even 10% annual return on your investment.
This is an Average return of 10% per year, and an Internal Rate of Return of 10% also.
After two years, your account would be valued at $121,000. Not bad, right? Sure would be nice if the world worked this way…..
Now, let’s input some volatility-
Scenario 2 shows a slightly uneven but still positive return. We’ll input 5% and 15% returns for years one and two respectively.
Notice, the arithmetic average is still 10% but the IRR is 9.89%, and the account is only worth $120,750! Same stated “Annual Rate of Return” of 10%, but you have less money!
Now let’s look again-
Scenario 3 shows a solid 20% gain in year one and a flat zero in year two. Guess what happens…..
This is another 10% average annual, but the account value is lower still…. Are you seeing a trend here?
How about one more?
Scenario 4 shows us a great example of what actually happens in the securities world. Let’s earn 30% in year one and lose 10% in year two. The results are even more depressing.
There it is again, that same solid average but the account is worth even less. Do you think I manipulated the numbers somehow? Remember, trust but verify. At this point, you should all grab a calculator and check my numbers.
OK- now for the final blow—
Scenario 5 illustrates a major blow to the account- Sounds like 2008, right?- followed by a giant rebound (We make NO promises of this!)
In this scenario, even a rip-roaring rebound of 50% gain in year 2 barely gets you above your original basis when you lose 30% in year 1.
In calculating returns, the Average Rate or Return of 10% is still technically accurate, but it masks the reality that you have only made a 2.5% annual appreciation, and have barely more than your original principal in hand after a wild ride.
So what’s the point?
The examples above illustrate the effect of volatility on an investment. Has the stock market ever returned exactly 10% two years in a row? The answer is no.
Now, imagine how long the odds are that it will return exactly 10% for ten, 15 or even 20 years….. Volatility is a fact of life in the securities world, especially in recent years.
In retirement planning, volatility is a demon to be avoided. Products that advertise a good rate of return can do so using the Average Rate of Return and be technically correct, and also be wholly inappropriate for a retirement investor.
Don’t expose yourself to unnecessary risks or technicalities! Safety first!
|Make sure you read how any investment is calculating its rate of return. “Average Annual Return” is very different than an a true measure of value- this is more properly titled ‘Internal Rate of Return’, ‘Yield to Maturity’, or ‘Effective Rate’.|
|Slow and steady guaranteed rates of return over the long term, especially in tax deferred appreciation vehicles, often outperform even aggressive equity portfolio allocations that swing down as much as they can go up.|
|It takes a very large rebound, which is historically unlikely, to make up for a large portfolio loss, which is all too common. Unfortunately, catching the loss is a lot more likely than timing the gain…|
|Remember, it’s YOUR money, NOT TheIRS. 🙂|