Average Return - It’s Not What You Think

Let's talk about a number you see all the time but probably misunderstand. The average return on your investments. It sounds simple, right? But this is a number that might be fooling you. And today we're going to pull back the curtain and see how. So, let me ask you something. When you look at your portfolio's performance over a few years, are you really truly confident you know what your actual average return is? Well, here's the thing. There's a very good chance that the way you've been taught to calculate a simple average is giving you a dangerously rosy picture of your success. And today, we're going to fix that. First, let's dive into what I like to call the average return illusion. This is where basic everyday math leads you to a conclusion that feels totally right, but is completely fundamentally wrong. And to really see this in action, we're going to use a super straightforward example. No complicated spreadsheets, promise. Just some basic numbers that are going to reveal a massive flaw in how we usually think about this stuff. Okay, so imagine you invest a hundred bucks in a single stock. Nice, clean, round number. That's our starting line. Now, in the first year, things do not go well. The stock just tanks. It loses half its value, a 50% drop. So, your $100 is now only worth 50. Ouch. But hey, in year two, the stock stages this incredible comeback. It doubles in value. That's a 100% gain. So, your $50 turns right back into $100. You're exactly where you started. So, after that wild ride, you're right back at square one. You've got a 0% gain, right? But here's where it gets weird. What happens when we try to calculate the average return for those two years? Well, if you do the math the way we were all taught in school, you take the year 1 loss of minus 50% and you add the year 2 gain of plus 100%, you get 50. Divide that by the two years and voila, you get an average return of 25%. But wait a second, and this right here perfectly shows the problem. The simple or arithmetic average tells you that you had this fantastic 25% annual gain. But your wallet, the actual result tells you that you had a 0% gain. You made absolutely nothing. See, the key thing to get is that claiming a 25% gain isn't just a little off. It's very misleading. It completely ignores the magic and sometimes the curse of compounding. that 100% gain in year two, it was on a smaller base of $50, not your original 100. Simple averaging just breezes right past that critical detail. Okay, so if that's the wrong way, what is the right way? Well, it's time to meet the hero of our story. A little something called C AR. CAGR stands for compound annual growth rate. Now, unlike that simple average, CAGR is designed to account for the effects of compounding over time. It answers the question you actually care about, which is, "What was the steady, smooth, year-over-year growth rate that would have gotten my investment from its starting point to its ending value?" So, let's move away from our little 2-year example and see how this works in a more realistic scenario over a longer period of time. This is where you'll really see how powerful CAGR is. All right, new situation. You buy a stock for 100 bucks. A whole decade goes by and you sell it for 280. Clearly, it was a great investment, but what was the real annual return? Now, the calculation itself might look intimidating, but it's really just a simple three-step process. Seriously, you don't need to be a math wiz. First, you divide your end value by your start value. Next, you raise that result to an exponent based on the number of years. And finally, you just subtract one. And if you want to see it as a formal formula, here it is. It's just those three steps we walked through, ready to be plugged into any decent calculator or spreadsheet. So, when you actually run the numbers for our example, turning $100 into 280 over 10 years, the true compound annual growth rate is 10.8%. What that means is on average, your investment grew as if it earned 10.8% every single year to reach that final value. Now, that is a useful real world number. But how big of a deal is this really? I mean, does that simple average always overstate your returns? The answer is a definitive yes and often by a pretty significant amount. You know, our first example wasn't just some weird cherrypicked fluke. It's actually a mathematical certainty. Because of market volatility, all those ups and downs, the arithmetic average will always be higher than the true CAGR, unless your returns were magically the exact same every single year, which, let's be honest, never happens. And to really drive this home, check this out. This is data from a massive simulation of 10,000 different 30-year investment periods. This simple, misleading average return came out to 7.1%. But look at the true number, the CAGR. It was only 5.7%. That is a huge difference in the real world. So the main takeaway here is this. Across 10,000 different simulations, that simple average overstated the actual returns by an average of 1.4% per year. Now 1.4% 4% might not sound like a lot, but believe me, over decades of investing and compounding, that gap is the difference between a comfortable retirement and well, not. Okay, let's just quickly recap the big points here. That simple average return you might be using, it's almost certainly inflated. Your investments compound, so you have to use a method that actually gets that. That method is CGR. It gives you the true annualized growth rate. And maybe most importantly, using the wrong number isn't just a simple math mistake. it can actually lead you to make some really bad financial decisions down the line. So, I'll leave you with this question. You now understand the illusion of the simple average and the power of the true compound annual growth rate. The next time you sit down to look at your portfolio, which one are you going to use to measure what really matters?