Don’t believe your lyin’ eyes: The truth about your “average” Rate of Return

August 3, 2020

My Dear Reader,

Whenever we finally get back to normal, whether it is in November or in a year’s time, I believe that the financial industry will pivot towards a more aggressive high average rate of return products. Before we decided to wreck our own economy, the main selling point for going with one Financial professional over another was to achieve a higher average rate of return. But would it bother you if you found out that the average rate of return does not give an accurate representation of the actual rate of return?  And would it bother you enough to do something about it? 

After nearly a decade of declining returns, we all wish we could see those 1980s-esque double-digit returns, but those won’t be back for a long time, if ever. So why do financial pundits still claim that you can get 12 percent in a mutual fund? I felt as though a proper answer could be gained by asking someone who formally based their life on them. I turned to budding Alaskan superstar Jerry Fetta, owner of Wealth Dynamix and Wealth Dynamix University, to ask him this very question, among others. He explained: 

“Mutual funds are reported with what is called average annual return, when, in reality, investments should be reported by compounding annual growth rate.” 

To put the financial jargon aside, what Fetta describes is exactly what I feared. The problem with math is that you can virtually make numbers say anything. So, by reporting the rate of return as an average, which does not translate to an actual return, those who push mutual funds are able to make their funds look more attractive in a sales pitch. Fetta is of the belief, as am I, that investments in nearly any market or industry should be calculated by an annual growth rate. In other words, how much more do I have in my pocket today that I didn’t have yesterday? Fetta goes on to explain that “[a] mutual fund can show mathematically the percentage went up over time. But again, if you measure ‘what did I start with versus what did I finish with,’ and I annualize that return and find out how much it was per year, [I] actually make significantly less money than I show on my return.”

For instance, if I had $1,000 in an account and the first quarter it went up by 100%, then in quarter two it dropped by 50%, before increasing by 100% in quarter 3 and then dropping by 50% in quarter 4 again, I would have earned an average rate of return of 25%.  You would rightly expect then to end the year with $1,250, right?  But if we look at what we actually earned, the answer is ZERO. In fact, if we account for inflation and taxation, we’ve actually lost money. This simple example is why I believe that in order to be more transparent with our clients and the general public, the financial industry should show the real rate of return over time.  As Jerry Fetta said, “What did I end with versus what I started with?”  For instance, gains on precious metals and real assets are measured in this way.  In a recent article in sovereign man investing, Simon Black notes the recent rates on Gold:

“Finally, there’s a theory that the gold price is correlated with ‘real interest rates’, i.e. the rate of interest after adjusting for inflation. This relationship is also far from perfect; real interest rates in 2011 and 2012, for example, were negative. Yet the gold price was falling. Real rates in 2017 were rising. But the gold price was also rising. So this theory is also flawed. The bottom line is that there’s no magic formula to tell us what the gold price should be. Dollar weakness, real rates, and money supply are all useful indicators. But they’re not predictors. It’s fair to say, for example, that gold is still undervalued right now relative to recent growth in the Fed’s balance sheet. Or that, over very long periods of time as central bankers print money and create inflation, gold tends to keep up.”

In my experience and in working with people who have made a great living in real estate, no one would buy a property based on an average rate of return. They would want, depending on what they’re buying the property for, a cash-on-cash return rate, or an estimated after repair rate. these numbers more accurately show the game that is to be had in investment or potential investment, yet the financial industry will consistently go back to the averages. and averages can be manipulative. I’ll leave the obvious conclusions as to why we focus on averages to you. 

To Your Creation and Potential,

Kevin Prendiville