Given the decade-long market recovery followed by the recent downturn, you may have questions about whether your money is really working for you. For example, is it possible to get an average rate of return of 25% and still not make any money? The answer is yes!” Stay with me for a math lesson on rates of return.
Understanding the simple truth that math doesn’t equal money can help you go from a passive retirement-seeking where you only half understand what’s going on, especially with all the negative news that can put you in a potentially constant state of panic, to one that is an active pursuit of your retirement goals and puts you in the best position to achieve them.
A recent survey by the American Psychological Association (opens in a new tab) found that problems associated with money are the biggest source of stress for most Americans, above worries about work, family responsibilities, and even health.
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Like me, you have nothing against financial firms, yet they can use math to skew the numbers in their favor to make things look better than they really are. The average rate of return on an investment is mathematics part of the situation, but may not necessarily result in money in his pocket, which is ultimately what we all want: he’s the one who pays the bills, does the shopping and covers the medical bills. We look to investment averages to provide a sort of beacon that we can lean on to make the best possible investment choices.
To help you understand the concept that math doesn’t equal money, I’ll start by using a hypothetical example with extreme numbers during four different time periods. I’m going to use two bull markets and two bear markets, so the results are clear.
Here’s how a hypothetical 25% rate of return doesn’t equal money
Meet Tom and Debbie. They have $100,000 to invest and have a four year timeline. They are open to growth and take a certain amount of risk. Tom and Debbie know they need to grow this money to meet their retirement goals. They meet with a financial professional and look at various portfolios and decide on a portfolio that has a historical track record of averaging 25% return in the allotted time.
At the start of the first half, Tom and Debbie start with $100,000 and see a bull market. They earn a 100% rate of return during that time. This will provide them with a return on their $100,000 investment, which is pretty sweet. At the end of the first bull market, they have $200,000.
They begin their second period with $200,000, but they are in a bear market and suffer a 50% loss on their investment. They lose $100,000 or $200,000. That gives them a final balance of $100,000.
They begin their third period with a balance of $100,000 and see a bull market. They earn a 100% rate of return on their investment, which is a $100,000 gain ending the third period with a total of $200,000, much better.
They begin their fourth period with $200,000 and experience another bear market in which they take another 50% loss on their money, losing $100,000 and ending that period with a balance of $100,000 in their account.
If you look at the math during these periods, Tom and Debbie gained 100% in each of the up markets (periods one and three) and lost 50% in each of the down markets (periods two and four). Let’s do the math: 200% gain minus 100% loss = total gain or 100%. If they divide that 100% return by the four time periods, they get an average annual return of 25%: 100% return divided by four periods = 25% average rate of return. This is math!
Let’s review the money: They started with $100,000, and after four different markets, ended up with $100,000, so their effective rate of return was ZERO, right? And that’s the difference between math and money.
The big lesson is this: Math doesn’t equal money in your pocket.
Here’s how a rate of return still doesn’t equal money
Let’s take a look at how this concept plays out in real life. By examining the average rate of return of the S&P 500 from 2000 to 2014, you can see how the average returns don’t tell the whole story about the real money in Tom and Debbie’s pockets.
If Tom and Debbie started with $100,000 in 2000 and let that account grow over the next 15 years (through 2014) using the performance of the S&P 500 total return index, they would have an account balance of $186,430. If they add up all 15 years of gains and losses, they get 91.38%, and if they divide the total by the 15 years, they get an average rate of return of 6.09% per year.
Let’s try the math to see if the actual account balance matches the average rate of return. I will perform a future value calculation by crediting 6.09% each year to their $100,000 deposit. When I do this, their account balance is not $186,430 but is instead $242,726. That’s a 30% difference between the two account balances! The S&P 500 rate of return may be mathematically correct, but that’s not the reality Tom and Debbie expect to see in their pocket where it counts.
Living and dying by market averages depends on your timing, exiting the market at highs and investing at lows… but it’s impossible to predict the future! This strategy does not give you the pocket money you expect. If Tom and Debbie started with $100,000 and ended up with $186,430 over a 15-year period, that gives an effective rate of return of just 4.24%. The bottom line is that even though the S&P 500 averaged 6.09%, the reality is that the actual rate of return is only 4.24%, proving once again that math does not equal money .
Math Doesn’t Equal Money: The Takeaway
It is very important that, like Tom and Debbie, investors and savers understand the difference between an average rate of return and the actual return on their investment. If you or your financial professional are making projections using average rates of return vs. current rates of return, could lead to a 30% difference between what was expected of you and the value of your account when it’s time to retire.
Bottom line: Math is just a number, while money is something you can take home with you. It’s what buys your groceries, sends your kids and grandkids to college, covers your medical bills—it’s your lifestyle security.
From now on, my hope for you is that you understand and live by this: average rates of return shouldn’t be considered when your lifestyle security may be at risk. There are always unknown forces at work within the financial markets, and it is impossible for anyone to predict when the next meltdown or “market correction” will occur.
The last thing you can afford is to stop the aggravating effect of our retirement money when it’s finally time to start living your dreams and enjoying your retirement. Just hoping for the best won’t work. Getting clarity on the reality of your approach by understanding this principle could be a step towards managing your expectations and ensuring you reach the retirement you want.
Questions you can ask your advisor to clarify the plan
Ask your financial advisor these questions for clarity:
- When providing projections, can you apply an actual rate of return versus an average?
- When it’s time to start supplementing my retirement cash flow with withdrawals from my investments, what’s a realistic withdrawal rate I can count on? And how do you know it?
- I’ve noticed that your projections suggest that I have an X% chance of success. What if I am unsuccessful? What is the contingency plan?
- What if the market is in a bearish or correcting state when I retire? How does this affect the cash flow we can get out of my portfolio?
This article was written by and presents the opinions of our contributing consultant, 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).