“There are three types of lies — lies, damn lies, and statistics.”
― Benjamin Disraeli
Earlier this month, we looked at the absurdity of Risk Assessment profiles. We examined how they can be used to create a false sense of security, suggesting to investors that they won’t lose more than the examples given, and that the upside potential is always greater than the downside. But the problem doesn’t end there…
What can cloud the waters further is the fact the average rate of return in the stock market is very different from the actual rate of return. And we’re not talking about fees or taxes (of course, those only make it worse) – we’re talking math. Not even complex math… it’s simple, pure math that most 6th graders can follow along with, yet very few adults (even financial professionals) have ever been made aware of the discrepancy.
How many investors experience putting more and more money into their 401k each month, only to realize, years down the road, that the account may contain nothing more than what they have personally placed in it? Where is the promised magic of compounding interest?
As we will demonstrate in this post, disappointing results can be explained by a curious mathematical observation. The difference between the average and the actual rate of return is a shocking “inconvenient truth” that could unknowingly cost even an average investor tens or hundreds of thousands of dollars over their lifetime.
This scenario is also demonstrated on the Truth Concepts blog, using Truth Concepts software, a suite of calculators and other tools designed for financial professionals. We’ll use their example of an imaginary $100,000 investment:
Original amount: $100,000
Year 1: 100% gain = $200,000
Year 2: (50% loss) = $100,000
The difference between the original amount and the amount at end of year 2, the real rate of return, is 0%. The investor ends with what they started.
However, the average rates of return are determined by adding rates together and dividing by the number of year in question. The average rate of return doesn’t consider the dollar amount; it looks at the average of the gains and losses measured as a percentage:
= 50% divided by 2 years, or, a 25% per year average rate of return.
Let’s take another simple scenario: Your account loses 50% the first year, and gains 50% the next year. A 50% loss and a 50% gain come out to a 0% average rate of return:
Year 1: (50%)
Year 2: +50%
Average rate of return: 0%.
Now, if the average rate of return equaled the real rate of return, you would expect the account to end the same as it began, with no gains or losses (not considering inflation, taxes, or fees, of course.) But what was the REAL rate of return? Let’s examine another imaginary fund of $100,000:
Original amount: $100,000
Year 1: (50%) = $50,000
Year 2: +50% = $75,000
Real rate of return: -25% (a negative 25%) over two years, or an average real rate of return of -13.4% per year. (It might seem like that would be -12.5% per year, but the calculator reveals the real rate of return is even lower, which accounts for a different year 2 starting basis.)
Yes, our imaginary investment LOST 25%. (Whew! Good thing we weren’t playing with real money!)
You might wonder if perhaps the numbers are just skewed because the losses came first. What happens if the account gains first? What happens if the account gains 50% the first year and loses 50% the second year… will we see a 25% gain?
Original amount: $100,000
Year 1: 50% = $150,000
Year 2: (50%) = $75,000
Real rate of return: (25%), or -13.4% per year!
Same frightening result!
Now, let’s look at a more complex 3-year scenario that might not be too far off to what some investors experienced during the recent recession:
Pretend your stock or mutual fund loses 40% one year, gains 30% the second year, gains 10% the third year. The rate of return might appear to be 0%, suggesting that losses had been recovered:
Year 1: (40%)
Year 2: 30%
Year 3: 10%
Total = 0% total (and average) rate of return.
Now, 0% isn’t a great rate of return, but it beats losing money, right? Let’s look again, and this time, let’s examine the REAL rate of return using another imaginary $100,000
Original amount: 100,000
Year 1: (40%) = 60,000
Year 2: +30% = 78,000
Year 3: +10% = 85,800
The REAL rate of return: (-14.2%), which over three years is a real rate of return of -4.98% per year (before taxes, fees, and inflation.)
Numbers Don’t Lie
It may not be logical, it may not be intuitive, it may even be downright disturbing, but the numbers tell the whole truth, but only when we apply them to dollars.
It is essential for investors to understand, when we’re shown charts about how the stock market goes up and down, yet produces solid, dependable “average rates of return,” we’re not getting the whole story. As a matter of fact, we’re getting a bald-faced lie – a lie that even most financial planners don’t realize they are telling!
How can we protect ourselves from misleading half-truths, limit our financial risk, and obtain reliable results? MORE…
1. Invest in financial instruments with reliable, even guaranteed rates of return.
Is it any wonder that banks prefer to put their “tier one” investments in solid, proven-through-recession investments such as life insurance, rather than take their chances in the stock market?
2. Utilize financial calculators or tools to calculate the real rate of return. Consult with advisors who use financial software such as Truth Concepts. If you are particularly astute with numbers and software, you can even learn to use Truth Concepts and other financial calculators yourself.
3. Be a financial free-thinker. Ask questions. Do your research. And whatever you do, don’t rely on glossy presentations based on past performance and “average rates of return.”
So… how else might we have been misled? We are celebrating the release of The Prosperity Economics Movement’s book: Busting the Financial Planning Lies, which explores the lies and half-truths about typical financial planning advice, 401k’s, mutual funds, real estate, taxes, and much more. Best yet, it shows you how the wealthy got that way by practicing “Prosperity Economics,” and how you can, too! Pick up your copy (paperback, ebook or audio) here.