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How the Average Annual Rate of Return Can Trip You Up

Beware of ads that tout an investment's "average" performance

by Bob Stokes
Updated: April 03, 2017

Would you invest in a fund with a guaranteed three-year average annual rate of return of 50%? The answer "yes" seems to be obvious. But let's take a closer look.

 

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[Editor's Note: The text version of the story is below.]

In the investment world, things aren't always what they seem. Here's what I mean:

Let's say you learned that a fund had turned in a three-year average annual return of 50%. Moreover, there were no fees, commissions or transaction costs.

Let's also say that author H.G. Wells let you use his famous time machine to go back in time to invest $10,000 into that fund. Would you?

Your answer would probably be something like, "Who wouldn't?"

But, before you get too eager to pull the levers and punch the buttons of the time machine, take a look at what our March Elliott Wave Theorist shared with subscribers:

Looking at the first table, you would have $15,000 after gaining 50% in the first year, $22,500 after gaining 50% in the second year, and $33,750 after gaining 50% in the third year.

The table on the right shows investors' actual results. In the first year, investors lost 90% and had $1,000 left in their accounts. At the end of the second year, they lost another 90%. In the third year, they notched a 330% annual gain. After three years, they had only a measly total of $430. ... The fund had an average annual return of 50%, but investors had 95% less than what they put into the fund three years earlier.

In other words, the fund's average annual return did not necessarily tell you what you wanted to know about its investors' past results.

Even using an average annual compounded rate of return doesn't do much better.

Let's now consider the DJIA, with another quote from our new Elliott Wave Theorist:

We crunched the numbers for the Dow Jones Industrial Average and found that the average annual rate of return in the index from 1901-2016 was 7.228%. But that's the benchmark that didn't work very well in the ... scenario above. So, let's try the average annual compounded rate of return across every completed 30-year holding period during that time, which is 5.222%. What difference does a two-percentage-point gap make when compounded over a 30-year period? Well, instead of turning a $10,000 investment into $81,142.09, you would turn a $10,000 investment into $46,046.49 ... a 43% shortfall from what you would have expected had you extrapolated the average annual rate of return across 30 years. ... Once you adjust for inflation, the real return has been only 2.414%.

And, of course, it will be even worse for buy-and-hold investors during the next bear market.

Our publications are alerting subscribers as to when we expect the next big market turn, a bullish or a bearish one.

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