Not All Returns are Equal
Those that work close with me know that one of my pet peeves is the way financial professionals and financial personalities talk about “average rate of return.” You’ve probably heard the market returns an average of 8% or 12% or some other number over a certain period of time. Those figures are probably true for taking the average of something over time using simple math to calculate an average.
But should that number be applied to expected returns of your investments in the market? Absolutely not! Average rate of return can be a simple shorthand to show growth and encourage investing but it has almost no correlation to what you will actually experience in your time in the market.
Morningstar is a popular place to go for investors and advisors alike. They evaluate the market, stocks, rate mutual funds and provide a one stop spot for most financial information you might need. Recently they produced an article called Not All Total Returns Are Created Equal. I wanted to highlight it to understand ACTUAL market returns, set proper expectations and scratch the itch that is my peeve about average rate of return.
It is important to know that every dollar you put into the market over time has a completely different ride in the market. Each month when your 5% 401(k) contribution goes in it goes in at a different time and different price. A fancy term we use for this is dollar cost averaging.
The article points out that your dollar could go in at a good time or a bad time. Think of going in at $100 and it drops to $80 or you go in at $80 and it jumps to $100. Ultimately, the article focuses on the sequence of your returns - perhaps one of the most import risk factors that is seldom talked about by industry professionals. The sequence or order of your growth and loss matters more than you know - especially when you are in the phase of using your money.
2 accounts with the same average returns could have wildly different outcomes given the order and level of the returns. This is part of the mystery of “money math” versus “school math.” School math is linear equations like average rate of return or compounding growth. “Money math” has added variables that make the equation complicated, mysterious and can cause headaches. This is why we default to what is simple.
Hopefully this article helps move us from the simple to the reality of the way things actually work.
You can check out Morningstar for lots of good financial information.
Here is a link to the original article.
https://www.morningstar.com/columns/rekenthaler-report/not-all-total-returns-are-created-equal
Here is a link to our Podcast episode about market returns.
https://podcasts.apple.com/us/podcast/whats-up-with-money/id1685985629?i=1000647424822
As always, if you come across a financially related article you’d like to send my way please do!
Best place to send them is to me.
More next time!
Jonathan