average vs real rate of return

I spoke to a lady the other day and for the sake of anonymity, we’ll name her Sarah.  Sarah went to a workshop seminar that was given by a fairly popular figure in the financial world. And I must say, I don’t always agree with his advice. In fact, oftentimes, some of things he says and the advice he gives is completely mind-boggling or, quite frankly, outright wrong.

However, I will admit that this particular individual has done a really good job in some areas. For instance, he not only has done a great job with helping people understand the downfalls of consumer debt, but has also encouraged people to not get into consumer debt in the first place. So he does get my kudos for being able to get quite a few people get on the right track with some of these issues.

The kudos stop there. Apparently, Sarah brought it to my attention that he was teaching something else, which then caused a lot of questions to arise. Her question to me was, “Where can I get a 12% rate of return per year on my investments?”

So I asked, “Where did you hear that you can get 12% per year?  Where do you think you would need to invest?  Do you think that’s a reasonable rate of return to base your retirement plan around?”  She told me that this gentleman said that over the long term you could expect to receive almost a 12% rate of return on your investments.

That really got my attention because if someone based their retirement plan upon receiving a 12% rate of return, it could leave them and a lot of other investors in an unexpected bind when retirement comes around.

According to Sarah, he apparently encouraged his listeners and readers to assume that they can expect average returns of about 12% on their invested money annually, and that they should use this when planning for retirement.  I think that’s quite a stretch!

When I tried to figure out why he chose 12%, and what he based it on, I found a claim on his website that referred to the average annual return of the stock market since 1926, which is very near 12% annually when adjusted for inflation.

Unfortunately, Sarah needed to understand that this is just not 100% true.  If you look at market returns as compiled by Yale economics professor Robert Shiller, the S&P 500 including dividends reinvested, has returned an average of 9.9% per year since 1926, and when that’s adjusted for inflation, it dips down to only 6.7%, which is a far cry from the 12% annually that he said to assume.

I can only suspect that for some reason he’s using average annual returns instead of the compound annual growth rate.

Oh boy. Watch out…

This is where you really need to be careful. If you ask me, the average annual return figure really isn’t that important. What is important, and I suggest it should be to you too, is the actual rate of return.

Let me give you an example to demonstrate the difference. Let’s say, for instance, you invested $100 in the stock market.  It could’ve been in a stock, a mutual fund, or an ETF—it doesn’t matter.  You invested $100 and then in the first year the investment goes up 100%. You would then have $200.  Well, year two comes around and the investment loses 50%.  Now you only have $100—right back where you started, right?  Here’s the thing though…

If you take 100%, which is the first year’s return, and you subtract 50%, which is the second year’s return, and then you divide that number by two, which is the number of years, you get the average rate of return as 25%.

Yes, it’s technically true to say that this particular investment averaged 25%, but the reality is that person actually started with $100 and two years later they had the same $100.

Now, if this investment returned 25% each year—if that was the compound annual growth rate—then by some quick math here on my calculator you should have about  $156 after two years, but that’s not the case.

In this case, you only have $100.  You started with $100 and you ended with $100; so the net effective rate of return after two years is absolutely zero.  The math does not work using average yearly returns.

I want to caution people who are using this advice. Making sure that you understand the distinction between average rates of return and compound annual returns is huge.

If you expect a 12% annual rate of return, this could be very dangerous when planning for retirement because it can set you up for false hope and a really cruel reality check as you get closer to retirement.

Let me give you an example. To really illustrate the power of this example, I’ll use a younger person. Lets take a 25-year-old that starts saving today and wants to retire when they’re 65 years old with a million dollars.  Sound okay so far?

If that investor assumes that he’ll make a 12% rate of return per year on his investments, he’ll need to save only $97 a month.  That’s it.  If, however, he assumes his return will be 6.7%, which is a much more realistic figure in today’s volatile investment world, that number jumps to $422 per month.  Think about that for a second, $97 a month versus $422 a month.  It’s an enormous difference.

For that investor who saved $97 a month and experienced the more normal 6.7% return per year, he would have approximately $350,000 at retirement age.  Therefore, he would end up having far less than he expected in retirement.

Again, I’m not sure why this 12% figure is being offered as something to rely upon, especially when there are no solid numbers to back it up, but you need to be very careful. Perhaps you can achieve a 12% rate of return over time. However, I don’t suggest you count on it.

Instead, be conservative in your assumptions. It’s better to have too much money than not enough!

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