Given the decades-long market rally followed by the recent downturn, you may be wondering if your money is really working for you. For example, is it possible to achieve an average rate of return of 25% and still not make any money? The answer is yes!” Hang on to me for a math lesson on rates of return.
Understanding the simple truth that math is not synonymous with money can help you move from a passive pursuit of retirement where you only half understand what is going on – especially with all the negative news that may put you in a potential state of constant panic – one that is an active pursuit of your retirement goals and puts you in the best position to achieve them.
A recent survey by the American Psychological Association (opens in a new tab) found that money-related issues are the top source of stress for most Americans, ranking above concerns about work, family responsibilities, and even health.
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Like me, you have nothing against financial companies, but they can use math to skew the numbers in their favor and make things look better than they really are. The average rate of return on an investment is the math part of the situation, but that doesn’t necessarily translate to silver in your pocket is what we all ultimately want — that’s what pays the bills, buys groceries and covers medical bills. We look to investment averages to provide a kind of guidepost to help us make the best possible investment choices.
To help you understand the concept that math is not synonymous with money, I’ll start by using a hypothetical example with extreme numbers for four different time periods. I will use two bull markets and two bear markets, so the results are obvious.
Here’s how a hypothetical 25% rate of return doesn’t equal money
Meet Tom and Debbie. They have $100,000 to invest and have a four-year time frame. They are open to growth and take some risk. Tom and Debbie know they need to put that money to work to help them reach their retirement goals. They meet with a finance professional and review various portfolios and decide on a portfolio that has a track record of averaging 25% return over time.
At the start of the first period, Tom and Debbie start with $100,000 and see a bull market. They earn a 100% rate of return during this period. This will get them a return on their $100,000 investment – pretty cool. At the end of the first bull market, they have $200,000.
They start their second period with $200,000, but they have a bear market and they suffer a 50% loss on their investment. They lose $100,000 of their $200,000. This gives them a final balance of $100,000.
They start their third period with a balance of $100,000 and see a bull market. They get a 100% rate of return on their investment, a gain of $100,000 which ends the third period with a total of $200,000 – much better.
They start their fourth period with $200,000 and experience another bear market in which they take another 50% loss on their money, losing $100,000 and ending that period with a balance of $100,000 in their account.
If you look at the calculations over these periods, Tom and Debbie gained 100% in each of the bull markets (periods one and three) and they lost 50% in each of the bear markets (periods two and four). Let’s do the math: 200% win minus 100% loss = 100% total win. If they divide this 100% gain by the four time periods, they get an average annual return of 25%: 100% gain divided by four periods = 25% average rate of return. It’s math!
Let’s review the money: they started with $100,000, and after four different deals, they ended with $100,000, so their real rate of return was ZERO, right? And that’s the difference between math and money.
The big lesson is this: math doesn’t mean money in your pocket.
Here’s how a rate of return still doesn’t equal money
Let’s see how this concept plays out in real life. Looking at the average rate of return for the S&P 500 from 2000 to 2014, you can see how average returns don’t tell the whole story of real money in Tom and Debbie’s pocket.
If Tom and Debbie started with $100,000 in the year 2000 and let that account grow over the next 15 years (until 2014) using the performance of the S&P 500 Total Return Index, they would have a account balance of $186,430. If they add up the 15 years of gains and losses, they get 91.38%, and if they divide that total by the 15 years, they get an average rate of return of 6.09% per year.
Let’s test the calculations to see if the actual account balance matches the average rate of return. I will run a future value calculation by crediting 6.09% each year on their $100,000 deposit. When I do this, their account balance is not $186,430 but $242,726. That’s a 30% difference between the two account balances! The S&P 500 rate of return may be mathematically correct, but that’s not the reality that Tom and Debbie expect to see in their pocket where it matters.
Living and dying by market averages depends on your timing, exiting the market at the highs and investing at the lows… but it is impossible to predict the future! This strategy does not provide you with the cash in your pocket that you expect. If Tom and Debbie started with $100,000 and ended with $186,430 over a 15-year period, that works out to an actual rate of return of only 4.24%. The conclusion is that even though the S&P 500 index averaged 6.09%, the reality is that the real rate of return is only 4.24%, again proving that the math is not not synonymous with money.
Math Doesn’t Mean Money: Takeaways
It is very important that, like Tom and Debbie, investors and savers understand the difference between an average rate of return and the actual return on their own investment. If you or your financial professional make projections using medium rate of return vs. real rate of return, this could result in a 30% difference between what was projected for you and the value of your account at retirement.
At the end of the line : Math is just a number, while money is something you can take home. It’s what buys groceries, sends the kids and grandkids to college, covers your medical bills – it’s the security of your lifestyle.
Starting today, I hope you will understand and live by this: average rates of return should not be relied upon when the security of your lifestyle may be at risk. There are always unknown forces operating within the financial markets, and it is impossible for anyone to predict when the next crisis or “market correction” will occur.
The last thing you can afford is to interrupt the cumulative effect of our retirement money when it’s finally time to start living your dreams and enjoying your retirement. Hoping for the best won’t work. Clarifying the reality of your approach by understanding this principle could be a step towards managing your expectations and ensuring you achieve the retirement you want.
Questions you can ask your advisor to clarify the plan
Ask your financial advisor these questions for clarification:
- When providing projections, can you apply an actual rate of return versus an average?
- When it’s time to start supplementing my retirement cash flow with withdrawals from my investments, what realistic withdrawal rate can I expect? And how do you know that?
- I notice that your projections suggest that I have an X% probability of success. What if I don’t pass? What is the emergency plan?
- What if when I retire the market is in a bearish or correcting state? What impact does this have on the cash flow we can get out of my portfolio?
This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SEC (opens in a new tab) or with FINRA (opens in a new tab).
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