PSA: Average Rate of Return vs. Actual Rate of Return
This is one that continually pops up on my radar since most of the financial world uses it to calculate a hypothetical future value of your investments.
People like me use “Time Value of Money” TVM calculators all the time - one of the most used apps on my phone. They are great for linear calculations and projections. They are at the heart of calculations on your 401(k) statement that make estimates into the future.
These calculations can be great for illustrating the importance of time, growth and value of having money at work, but the use of average rate of return should be cautioned against with regards to the expected value of your money in the future. That can be a dangerous game and one that will leave you disappointed.
Why?
No doubt you have seen a video, or a dozen, that say, “invest X dollars in a Roth IRA every year for 30 years and get a 10% rate of return because that is what the S&P 500 has averaged forever and you will have a million dollars.” Aside from being a horrible run-on sentence, this is far from how the market works and your account value will probably be at least 25% less than that million dollar projection.
This has to do with different types of math, rather different types of calculations. One is linear and takes the average rate of return over time and applies that to every year (average rate of return). The other calculation looks at the actual effect that market returns have on money. For example, a market loss can make your actual return 0 and your average return positive.
EXAMPLE:
$1000 goes up 100% = $2000
$2000 goes down 50% = $1000
Average was +50%. The Actual was 0%
Here are a couple of key things to ask your advisor or the financial professional you work with to go beyond averages and get closer to real numbers.
How have you calculated market losses (or multiple market losses) into this calculation?
What would a significant market correction (25%, 30% or 40%) do to this account?
Can you show me this in 3 ways, the best market conditions, average market conditions and the worst market conditions?
These things matter, especially over time.
$5000/year into an account over 30 years can end in very different places and 1% can be huge.
10% return: $822,000
9% return: $$681,000
8% return: $566,000
5% return: $332,000
Average Rate of Return is a great tool and should be used for some things when calculating financial matters, yet, for the specifics and for proper expectations and outcomes, focus your attention and questions to Actual Rate of Return and the actual effect of market ups and downs have on your money.
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