In the world of personal and business financial planning, it’s hard to go very long without discussing rate of return. For decades, brokers and advisors have used it as the primary selling point for many people to buy investments. In many cases, return on investment is the primary measure of financial success.
Well, I’ve discovered that rate of return is just a fraction of what truly successful investors, planners and advisors focus on. Rate of return is very much overrated. This is partly because building a solid, comprehensive financial situation is much more than simply a rate of return. It’s also because the math behind the rate of return is misunderstood and misconstrued. Let’s explore why.
Rate of return is analogous to the engine of a car. Yes, it’s important to have a well-tuned engine and it helps to drive a fast car, but the engine isn’t the whole car. You have the brake system, the cooling system, the air conditioning, the power seats, the stereo system, the size of the car, etc. It’s all these components in unison that create the experience of driving a car. It’s also why some people choose a more economic, practical minivan over a speedy roadster designed to go from zero to 60 miles per hour in less than four seconds.
In the same way, a rate of return is merely a component of your financial success. Other factors, such as protection, legal, cash flow, tax and estate planning, are all equally if not more important than the speed at which your investments are growing. Yet, these factors are often overlooked or ignored because the rate of return is a sexier and easier discussion to have. It takes a great deal of expertise to understand how all these other components tie together. Rate of return, on the other hand, is easy to comprehend and talk about. Or is it?
The rate of return you see on paper is not necessarily representative of what you’ll get.
The fundamental reason is the difference between what’s called “nominal return” and “geometric mean return.” Nominal average rates of return look very different than what you’re really earning in terms of gains. For example, imagine you start investing with $1,000. Let’s track your investment’s progress over four years
So, you started with $1,000 and, after four years, ended with $1,000. What’s your rate of return? It is 0% because your money has not grown at all. After paying fees and potential taxes, you’ve achieved a negative return on the investment.
Now, let’s calculate the average rate of return by adding up the returns and dividing by the four years we held the investment.
Your account has a +25% average rate of return, but your real rate of return was negative. The problem with nominal rates of return is that they are calculated in percentages. What you get in your portfolio is not calculated by percent, or “per one hundred.” It’s your real dollars that are changing in value each year. Recovering a loss in a down year means you have to achieve a greater percent, or “per one hundred” value, to make up that loss because your principal has dropped.
The geometric rate of return and the real rate of return factor in money deposited or withdrawn, taxes, fees, inflation and other factors that can drag your rate of return down. These can better indicate your true return on investment. I mentioned earlier that these factors are often ignored. I believe this is a major contributor to why people feel shorted or unsuccessful when it comes to saving and investing money.
A rate of return does not factor in volatility, or what’s called “sequence of returns.”
A nominal average does not care the order in which numbers are achieved. You add up the numbers and divide, so the order is not relevant. In your portfolio though, volatility and sequence of returns is everything. Here are two portfolios. Notice the returns vary from year-to-year, but the average rate of return for each is the same: +3.5%.
So, if both portfolios held $100,000, shouldn’t they both have the same results after four years? Contrary to what appears logical, after four years Portfolio A has $111,429 and Portfolio B has $113,848 — a difference of over $2,400.
Compounding interest is an overrated miracle.
Albert Einstein is rumored to have said that compound interest is the greatest force in the universe. Financially, this is true — in a vacuum. Here’s why. Yes, it is true that if you invest $50 a week between the ages of 25 and 65 with an average rate of return of 6%, you’d have a total of $402,387. That’s remarkable growth with an annual savings of just $2,600. The problem is, everything else is inflating at the same time. The prices of gas, food, housing, technology and lifestyle are also compounding in value. These factors diminish your real rate of return and purchasing power. Unless you’re counting on your money compounding in value in a vacuum, projections showing the power of compounding are misleading.
From retirement plan projections to investment portfolio comparisons to hypothetical insurance and annuity calculations, charts showing nominal rates of return compounding over time are all over the place. If you’re planning is based on these projections, beware of results that may fall short of expectation. In these examples, I assumed rates of return would be positive. Imagine if your portfolio experiences a market correction. How would this affect you?
Speak to your advisor about this important statistic. Rate of return is not just overrated; it’s misunderstood, misused and often sold with a promise that can’t be fulfilled. What good is a 400-horsepower car engine if you don’t have any brakes?