Don’t Overrate Your Rate of Return
29 Sep 2015
Numbers, as we all know, can be deceptive at first glance.
Let’s consider this scenario: Your colleague at the water cooler, Ken Jones, starts bragging one day about how great a performance he has seen with one of his investments. “You should check out that rate of return!” Ken says. “Sure, there are some off years, but wow just look at how well it’s done on the average.”
Let’s say that Ken has an investment that starts out with $10,000. Now, imagine an amazingly good year. It goes up 100 percent, and he has $20,000. The next year is horrible: Ken takes a 50 percent hit. That means after two years of investing, Ken is back where he started at $10,000. So what was Ken Jones’ average annual rate of return? Well, the average of those two percentages is a 25 percent gain. So, Ken could go tell his friends he posted a 25 percent return. He might not want to add that he has nothing to show for it.
There tends to be overemphasis on rate of return, as I believe the concept of consistent compounding is either under valued or perhaps misunderstood. I would much prefer a steady rate of return year after year without volatility. Every compound interest table or financial calculator that is found online is built upon zero volatility. It’s based upon a consistent rate of return. Don’t let the numbers deceive you.
For more scenarios on topics like this one, pick up a copy of Stop Trying to Keep Up With the Joneses: They’re Broke Anyway.