If you invested $10,000 into two different accounts, and after ten years, the average return for both was 7%, would both of your accounts hold the same amount of money?
Surprisingly, the answer is no – in fact, in some cases, not even close!
That’s because the actual return that you attain has a lot less to do with the average return on your money. But that’s not what the average financial advisor wants you to know.
Smoke in Mirrors Versus Actual Return
Most stock market benchmarks, such as the Dow Jones Industrial Average, as well as most mutual funds, will provide their average returns over a certain period of time. These time periods can be short, such as one year, as well as long, such as five, ten, twenty, or more years.
These average returns are touted all over the place, and – provided that they are positive, they are usually presented to prospective investors (of course, with the caveat that “past returns are not indicative of future performance”).
But even if the investment has a stellar performance in a given year, the actual dollar amount that you are positive or negative won’t necessarily reflect a substantial gain. That is because the more your return falls in one year, the more it will have to make up going forward just to get you back to even again.
For instance, take a look at the chart below. If an investment falls by 20% in Year1, it will need to go back up by 25% just to get back to square one. If it drops by 50% in Year 1, a 100% gain is required the following year just for it to get back to even, and so on.
Percent Loss Drawdowns vs. Percent to Recover
|% Loss of Capital||% of Gain Required to Recoup Loss|
In looking at actual dollar figures, let’s say that you invested $10,000 into an account, and in the first year, the return drops 50%. In this case, you would end up with $5,000 at the end of Year 1.
In Year 2, the account experiences a positive 50% gain. So, are you back to having the original $10,000 you started with?
Not even close – because a 50% gain on $5,000 will only bring you to $7,500, not $10,000. Therefore, your account balance at the end of Year 2 is still 25% less than the $10,000 you started with at the beginning of Year 1.
Let’s take this example one step further. In Year 1, say you had a return of -50%, and in Year 2 you experienced a return of 50%. That comes to an average return of 0% – right?
Yes, that part is true. Your AVERAGE return is 0%. But, because you started out with $10,000 and you now have only $7,500 your ACTUAL return is negative 25%.
In fact, as long as there are any negative numbers in the mix, the actual return will never equal the average return. Here is an example of how a $1,000 investment that vacillated between positive and negative yearly returns of 10% would look over a ten-year period of time.
|End of Year||Gain or Loss||Value of Account|
Source: The Retirement Miracle. By Patrick Kelly.
Here again, even though the average return is zero, the actual return is roughly a negative 5%. With that in mind, be careful of the “smoke in mirrors” tactic that is oftentimes used by investment advisors who try to lure you in with “average” returns – because more often than not, the returns that they are showing you are nowhere close to the actual performance.
How to Ask the Right Questions Before Parting with Your Hard Earned Dollars
While investment return charts can oftentimes look like a heart monitor in the ER, by asking the right questions about a financial vehicle that you’re considering, you can get a much better feel for how your money might actually perform.
If you’re considering the purchase of an annuity, and you want to get an idea of how it may perform for you, we can help. Today, with so many types of annuities to choose from, it can be overwhelming at best to narrow down the right one for your specific needs.
So, before you take the next step, contact us here. We specialize in reviewing and analyzing all types of annuities – and how they actually perform – so that you know what you can expect going forward.