If an investment advisor is touting an impressive average rate of return, beware, because losses can “hide” among gains and hurt your financial success. Let’s explore the meaning of the average rate of return versus the actual rate of return.

Your most compelling reason for making an investment choice may very likely be based on one performance criterion: rate of return. But are you seeing it the right way? When I meet with potential clients, I’m often asked what kind of average rate of return they can expect. But if you rely on the medium rate of return, you are making a big mistake. Be careful not to fall prey to this type of thinking and take advantage of it.

There are actually two different types of rates of return, and they are not created equal: the average rate of return and the actual, or real, rate of return. The worst result of making investment decisions without understanding how rates of return work, coupled with how rates are affected by the sequence of return risks, is that you could dramatically shorten the life of your money at retirement.

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What is an average rate of return?
The average rate of return is a simple calculation: add up all your annual investment returns and divide by the time spent. Financial advisors often use the average rate of return as an advertisement for the product they usually offer.

For example, consider the following investment of $100,000 over a five-year period:

Year 1 = $107,000 (7%)
Year 2 = $114,490 (7%)
Year 3 = $122,504 (7%)
Year 4 = $131,080 (7%)
Year 5 = $140,256 (7%)
As you can see, after five years the investment had an average rate of return of 7%. This was accomplished by adding up each annual return and dividing that number over the five-year period. In fact, I often see projections from other financial advisors that use the above example almost verbatim. But you know there will never be a five-year period where investment returns are exactly the same every year.

What many may not realize with an average rate of return is that due to the nature of the calculation, gains in some years can mask losses in others. The bottom line is that while an average win may look good, it may leave you with less money in your pocket than expected. For example, Walmart (NYSE:WMT) shares returned 9.1% in 2014, lost 28.6% in 2015, gained 12.8% in 2016, gained 42.9% in 2017, and lost 5.7% in 2018. The average Walmart stock return (opens in a new tab) over these five years is 6.1% (30.5% ÷ 5 years = 6.1%). Any type of investment in stocks, bonds or mutual funds will always result in gains and losses.

What is the real rate of return?
The real rate of return is a process of recalculating and adjusting investment returns to account for both gains and losses.

For example, consider the following investment of $100,000 over a five-year period:

Year 1 = $120,000 (20%)
Year 2 = $130,800 (9%)
Year 3 = $107,256 (-18%)
Year 4 = $116,909 (9%)
Year 5 = $134,445 (15%)
Again, after doing the math, you will see that after five years, this investment also had an average rate of return of 7%. The main distinction is that the end result of $134,445, or an actual rate of return of almost 6.1%, is almost $6,000 less than the previous example of $140,256. The average rate of return might have been the same, but the money in your pocket certainly isn’t.

Conclusion: the real rate of return is much more telling
Investors should be interested in the actual rate of return – not an average – because investment losses can be easily hidden by using an average rate of return.

If you look at this as a simple equation, then there is no difference, as both examples ended up with an average of 7%. However, from an actual investment value, including both gains and losses, there is an obvious disparity.

When working with a finance professional touting their average rate of return, ask them to show performance with actual dollar amounts.

How the sequence of returns risk affects the rate of return
As we age, the risk of loss can significantly reduce the ability to make our money last in retirement. According to Allianz Life, 63% of Americans fear running out of money in retirement more than they fear death (opens in a new tab) .

While losses may not affect us during the accumulation phase of our working years, they will certainly hurt us during our distribution phase in retirement.

Let’s use the previous two examples but include an annual withdrawal of $4,000:

Example 1:

Year 1 = $107,000 (7%) – $4,000
Year 2 = $110,210 (7%) – $4,000
Year 3 = $113,645 (7%) – $4,000
Year 4 = $117,320 (7%) – $4,000
Year 5 = $121,252 (7%) – $4,000
Example #2:

Year 1 = $120,000 (20%) – $4,000
Year 2 = $126,440 (9%) – $4,000
Year 3 = $100,401 (-18%) – $4,000
Year 4 = $105,077 (9%) – $4,000
Year 5 = $116,239 (15%) – $4,000
According to the results above, the first example was still $5,000 ahead of the second after taking withdrawals into account. As a result, a loss changed the balance at the end of the fifth year, even though the average rate of return was the same.

Keeping losses to a minimum with proper investment allocation, especially as you approach retirement, can have a significant impact on your financial success rate.

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) .