Many people have money invested in the stock market.
Either directly or through their investment for retirement.
When advertising for your investment dollars, companies show you all kinds of graphs and average returns their investment strategy has historically provided in the past.
They often talk about the long term average returns from investing in the stock market.
Using a simple average return is misleading.
Your actual returns will be lower, and I am not talking about fees, transaction costs and tax (although these all can greatly affect your returns as well).
Averages can be highly misleading.
For instance a river may have an average depth of a foot and seem safe.
But this could mean a small part is 10 feet deep and the rest a few inches.
Simple averages do not allow for volatility in stock market prices! Many part-time investors never really think about how the changes up and down in the stock market truly impacts there investment returns.
Effects of volatility and negative returns For instance, a drop of 50% in the market means you need a rise of 100% to get back to where you started before the fall.
You break even, although your average return appears to be 25%.
That's why you have to be careful with how you look at the information.
Your compounded average return is 0%.
The greater the volatility in the stock market, the more it drags down the compounded return from the average return.
Have a look at this simple example of hypothetical returns.
Year 1 A= 10% B= 5% C= 30% D= 15% Year 2 A= 10% B= 10% C= 0% D= 10% Year 3 A=10% B= 15% C= 0% D= 5% Simple Average A= 10% B= 10% C= 10% D= 15% Compound Average A= 10.
00% B= 9.
92% C= 9.
14% D= 9.
92% As you can see.
The greater the variation, the lower your compounded average return is from the simple average.
And, the order of the variation does not make a difference (compare B and D).
Does this make a big difference in the real world? Yes.
The simple average return from the USA stock market from 1900 to 2002 (excluding dividends) was 7.
2%.
But, the compound average return over the 103 years was 4.
8%.
It is the compound average return that dictates what money you will have at the end of the investment period.
Even worse, the compound average return does not include inflation.
That is, it is the nominal return, not the real return.
To calculate your real return you would need to adjust the compound return for each year by taking off inflation (or adding a percentage during deflation).
This allows for the reduction in purchasing power of your money over time.
Does this make much difference in the real world? Absolutely.
For example, the inflation rate over the same 103 year period mentioned earlier averaged around 2%.
If you invested $1000 and got a 7.
2% return for 100 years you would have roughly a million dollars.
At the actual compound rate of 4.
8% you would have just over $100 000 after 100 years.
Allowing for 2% annual inflation the value of your investments would in realty be worth about $14 000.
What if we include tax? Well, that would depend on whether you were incurring on-going tax, or perhaps paid tax only after 100 years by selling only at the end.
Usually, you have to keep buying and selling stocks in a portfolio or fund on a reasonably regular basis.
Simulating the real effect of taxes is way beyond the scope of this article- so let's keep it simple and say we pay no yearly taxes and sell the lot after 100 years.
And we pay an average of 25% tax on the profits.
We are now down to nearly $10 000.
I think you get the picture.
So I won't include the effect of fees or transaction costs on your long term likely gains as well.
Summary: Look closer at the advertised returns historically made by investment funds.
And consider what happens in the real world to your investments.
Note: this article in no ways represents financial advice to individuals.
It is simply an educational article suggesting that readers should learn more about what impacts investment performance.
Past performance of markets is not a predictor of future performance.