Is “annual return” a good measure of how your investments are doing?
If your investment account is returning average returns, you might be satisfied with your investments. After all, doesn’t that mean “you’re not losing money?”
But while average is fine in some areas of your life, it may not be enough if your investments give you an average rate of return.
Good math doesn’t necessarily mean money in your wallet
The most common statistic people use to measure an investment is its return — how much money they made. If the investment was held over a period of years, they add the returns for individual years and divide by the number of years.
But sometimes people don’t make the average return. Here’s why: Let’s say someone has a $100,000 portfolio, and makes an average of 6% ($6,000) per year. He earmarks this return to pay for his family vacation. Assuming he makes exactly 6% per year, not considering taxes, he’ll have enough money to pay for vacation.
But, in the real world, investments don’t always work the way we wish. Let’s say that that in year #1 he only makes 3% on his investment, $3,000. He won’t be able to pay for vacation. And, if the next year, he makes 9% ($9,000), he can go on a super-fancy vacation. His average return for both years is 6%, but the real take-home amount is quite different.
Be sure to consider this reality check when working on your financial plan. Ask your financial planner about “Monte Carlo” simulations that consider this very issue: how will different possible returns in the portfolio affect the principal? Does the order in which you make your yearly returns affect the long-term bottom line? The answer is “yes,” and you should design your portfolio to take these different possible market scenarios into account.
Click here to learn more about how to invest when you can’t predict the markets.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published October 20, 2013. Updated January 2019