Let’s examine one of the “unintended consequences” of volatility: poor returns that don’t match expectations.
There’s a dirty little secret in the financial world, and it’s this: “The Average rate of return doesn’t equal Actual rate of return.” We say this often to clients, readers, and advisors so they can understand why investments rarely grow as much as you expect!
I explain the “average vs. actual” rate of return concept in one of my Money Myth videos: “Money Myth #6: Average Rate of Return Reflects Actual Rate of Return.” And we even prove it on calculators at Truth Training, the training my husband, Todd Langford, conducts with advisors and other financial professionals.
It’s why money earning “an average rate of return of 10%” might actually grow by only 7 percent per year! In this article, we’ll look at a new way of expressing this truth, drawing from some savvy analysis and commentary from Hans Wagner. We’ll also add our own observations about why it matters and what you can do about it!
Following a disciplined process using sound investment principles over many years, Wagner was able to quit his job at 55, “retiring” to the work of writing and teaching about investing. In his article in InvestingAnswers.com, “CAGR vs. Average Annual Return: Why Your Advisor is Quoting You the Wrong Number,” Wagner demonstrates:
1. Your Compound Annual Growth Rate (CAGR) won’t match your average annual rate of return. (The exception is when your investment earns the exact same interest rate each year, then the CAGR will be the same as the average annual return.)
2. Your CAGR reflects your actual rate of return, which is typically less than your average rate of return, regardless of whether your account starts out with a winning or a losing year.
3. The more volatile the market or the investment, the greater the difference between your Compound Annual Growth Rate and the average rate of return.
There’s no doubt the wonder of compounding interest has helped many people grow fortunes large and small. Yet the compound annual growth rate (CAGR) is constantly being confused with average rates of return.
Brokers and advisors prefer to quote average rates of return, perhaps because the average rates of return are consistently less impressive than the Compound Annual Growth Rate, which is the actual rate of return. Wagner explains the confusion:
The best way to explain it is to start with an example. Imagine you have $10,000. This year, your $10,000 grows 100%, leaving you with $20,000. The following year, your investment falls 50%, taking you back to your original amount, $10,000.
So over the two years, your annualized gain is zero (basically, you’ve neither made nor lost any money). The zero percent you received is known in the financial world as the Compound Annual Growth Rate (CAGR).
But an advisor eager to put some positive spin on the situation may tell you that your return is actually 25%. That number is called the average annual return and is actually very misleading. Hey, if you had made 25%, wouldn’t your portfolio be bigger than when it started? In real life, you only realize the CAGR, not the average annual return many brokers and fund managers claim.
The culprit is market volatility.
How Volatility Erodes Market Returns
The roller coaster ride of the stock market is what causes the actual rate of return, the CAGR, to be less than the average annual return quoted by planners and brokers. And that difference is what makes investors wonder, “Why isn’t there more money in my 401(k) if I’m earning X% interest? Why does it seem like I just have what I put IN to the account?” Wagner notes, “The more volatility experienced by the market, the larger the drop in the compound return.”
The two factors that contribute to volatility are negative returns and the distribution of the returns. The more volatile an investment is, the lower the actual investment return will be. As Wagner observes, “Whenever you lose money, it takes a greater return to just break even. If you lose 20%, you must earn 25% to get back to where you began. The more you lose, the worse the situation gets. Lose 50% and you must double your money (grow by 100%) to get back to even.”
And it doesn’t matter if the losses or gains come first. For example: If you start with $100,000 and you earn 50% in one year, you’ll have $150,000. But what happens if the market LOSES 50% the next year? Your investment drops to $75,000. Your annual average rate shows a 50% gain and a 50% loss, which makes the average annual rate of return 0%. But you didn’t end up where you started, you ended up LOSING 25% of your investment in 2 years! That’s a Compound Annual Growth Rate of -13.4 not 0%!
Reversing the order gives the same result. If you started with $100,000 and lost 50% in the first year, that would leave you with only $50,000. A 50% gain the following year would bring your $50,000 up only to $75,000 the second year. In either scenario, the 0% average annual return resulted in a 25% loss, or a CAGR of -13.4%.
Why the Distribution of Returns Matters
Now let’s look at how the distribution of returns affects the CAGR. As you’ll see, you can have no negative years at all, yet still have a CAGR that falls below the average rate of return. As you’ll notice below in Wagner’s examples, as the distribution of returns widen, the compounded returns shrink.
In Scenario 1, you see the average annual return and the compound are both 10%, because there is no deviation. But in each successive scenario, the distribution of returns widen as the average annual portfolio returns shrink. Wagner summarizes: “The greater the distribution of returns, the lower the compound returns you receive.”
When negative returns are combined with a greater distribution of returns, average returns suffer even more. In the example below, the portfolio gained two years in a row, followed by a negative year. And as the scenarios progress, the good years get better while the bad year is even worse, with progressively disastrous results:
What does this mean if you are invested in the stock market? Says Wagner, “Historically, the market is either up or down by 15% or more about half of the time. This means that you should expect negative returns and a wide distribution of returns each year.”
In other words, don’t expect your Compound Annual Growth Rate to resemble the average annual returns of a particular stock or mutual fund! And while this presents a challenge to be conquered for Wagner and other active investors whose aim it is to “beat the market,” we see it as a challenge to be avoided if possible.
Market volatility is one reason the Dow Jones, even with its impressive recent highs, has only managed to average about 6% compounded annual return since its previous high in 2007. (See “The Ups and Downs of the Dow Jones” for more, written a year ago when returns were even more disparaging.) And yet, the roller coaster ride is addictive, both for those who love to play the game and for those who simply keep finding themselves trapped on the roller coaster, waiting for values to rebound after they jumped in “too late.”
We don’t have a crystal ball, nor do we enjoy speculation, so we advocate for investments with predictable, reliable returns not subject to the roller coaster ride of the market. Even Warren Buffet, who popularized “Rule #1: Never Lose Money” lost a LOT of money in the Financial Crisis. And if the Sage from Omaha couldn’t protect himself from a catastrophic downturn, we won’t pretend to be wiser.
Then how can you guard your wealth against volatility? How can you achieve Compound Annual Rates of Return that resemble average annual rates of return?
For starters, STOP searching for “the next hot stock,” speculating with dollars you can’t afford to lose, and assuming that healthy returns and high risk go hand in hand. Next, consider the three strategies we like and use personally as well as recommend to our clients:
First, allocate assets to non-correlated investments that aren’t subject to market crashes, interest rate fluctuations, or political unrest. Our favorite non-correlated investment for growth relies on actuarial math, not investor luck or skill to earn healthy returns. Life Settlements represent the secondary market for life insurance policies. (An interesting note: since the Financial Crisis, Buffet through Berkshire Hathaway as well as Bill Gates have invested large sums in life settlements.) Contact Partners for Prosperity for details and access to a life settlements video.
Second, diversify with bridge loans and other private lending opportunities to reduce volatility, replacing a portion of your portfolio with contractual agreements that bring in steady income. While not entirely insulated from markets, private lending is an excellent way to diversify and create cash flow for both non-accredited investors as well as accredited investors.
Third, double down on your savings. Put more assets in vehicles where gains are guaranteed to guard against volatility and sleep soundly at night! We personally use whole life insurance for our long-term savings, as the returns are much higher than bank accounts and there are important additional benefits:
- the ability to leverage liquidity
- a permanent death benefit
- tax-deferred, sometimes tax-free growth, and
- optional riders such as paid-up additions accelerated death benefit and long-term care riders.
Finally, if you are invested in the stock market, don’t fall asleep at the wheel. Limit your risk exposure with strategies such as trailing stops and proper diversification.
Want to Know More?
Sign up for your complimentary Prosperity Accelerator Pack and receive a copy of the Financial Planning Has Failed ebook for more details on Prosperity Economics and each of the above strategies.