contributed by Nathan Gehring
Average investment returns, it’s something that comes up all the time when discussing investments or economics. From time to time, it can be helpful to be reminded that average returns often don’t tell much of the story.
For this week’s post, I’m going back to basics with a real simple exploration of how average returns can often be very misleading and not really tell you how much you have or have not benefited. The hypothetical example below is extreme, yet the math is real and important to understand.
Assume you invest $10,000 today and you get the following returns over the next two years:
Year 1: -50%
Year 2: +100%
What happened to your $10,000 investment? Let’s look:
Year 1: $5,000 lost — year end investment value = $5,000
Year 2: $5,000 gained — year end investment value = $10,000
But what happened to your average annual return? The math is simple. Add all yearly returns up, and then divide by the number of years.
Year 1 average return: -50%
Year 2 average return: +25% (-50%+100%=50% — 50%/2 = 25%)
The math shows that you have an average annual gain of 25%. But you have exactly the same amount of money as you began with!
Let’s extend it another year with a 0% return, so you end up with $10,000 after the third year.
At the end of year 3, the investment value = $10,000; for an average rate of return of 16.67%.
Three years on, you’ve earned exactly $0, but still show a significantly positive average annual return. And you can keep doing this ad infinitum with 0% return (Year 4 = 12.5%, Year 5 = 10%, Year 6 = 8.333%…). Despite never earning one penny of additional wealth from your initial investment, the average return remains positive.
Often when people discuss investments or economic growth in informal settings or with back-of-the-envelope math, this type of simple averaging is used, resulting in potentially misleading numbers. Just remember that average returns are only average storytellers and often don’t tell you what’s really happened.