It’s not uncommon for people to base major decisions in their lives on the perceived odds of how that decision will pan out for them. Odds are like averages where the positive and negative outcomes are weighted to help people make decisions with their lives.
However, when it comes to average returns, that kind of weighted analysis is very often misleading. Some investors only look at the average return on their potential investments in order to make their decisions. This investment model often leads to disastrous consequences that can leave your retirement portfolio seriously lacking in necessary funds. That’s why it’s important to start saving early and make informed decisions with your investments.
What are average returns?
As the name suggests, average returns are the mathematical average of a series of investment returns that are generated over a period of time. The number is calculated by totaling the value of all of the investments into a single sum, and then by dividing that total sum by the amount of returns.
The purpose of an average return is to give investors a single metric to use when comparing the performance of various investment choices. Many investors go no further than comparing average returns when choosing between investment choices. Their thinking is that the past performance will predict future returns, which will help grow the value of their investment portfolios so that they can achieve their desired goals for retirement.
Average returns are like average temperatures
Unfortunately, it’s not that simple. Average returns are very similar to average temperatures. All they do is provide a snapshot of a selected past time period. Nothing more. Like trying to predict the weather too far in advance, it is easy for investors to make the mistake of assuming that present market conditions will deliver similar returns in the future.
Think of it this way. Suppose you’re looking to retire somewhere with a mild climate. You do a little research and you find out that two great American cities, St. Louis and San Francisco have an average temperature of 65 degrees. Then, you do a little more research and you find that, while San Francisco is pretty much 65 degrees most of the year, St. Louis has hot summers and cold winters. You wouldn’t account for those temperature fluctuations if you were only looking at the averages.
The averages plus variability = perspective
Rather than use average returns alone as a basis for your investment decisions, it’s useful to also understand an asset’s variability. In other words, how high are its highs and how low are its lows. Said another way, how should we expect this investment to behave through time? What does its normal price behavior look like?
Take the Standard and Poor’s 500 index for example. It has had numerous ups and downs over its 90 years of existence. It’s average return is around 10% but there have only been a handful of years where the index actually hit that average. It has fluctuated widely from year to year on its way to earning that average return.
In fact most of the time the S&P 500 Index varies year to year by as much as 15%. Anywhere from -5% to +25% is considered normal annual variation for the S&P 500. Think about how that knowledge might impact how patient you would be as an investor. Any annual return that lands in that range is normal. Nothing to get excited or concerned about.
The lesson is: if you base your investment decisions strictly on average returns, you risk misleading yourself and disappointment. There is a bigger picture that includes how an investment behaves as well as what it has earned.
Work with a financial advisor to plan for return variabilities
Understanding how average returns and volatility work together is one of many challenges that investors can struggle with when making their financial plans. The markets are complicated and the needs for a comfortable retirement are many. It’s tough to navigate the complexities and the emotions of investing alone.
This is why it makes sense to work with a financial advisor who uses tools that account for the variability in returns. Good planning is an ongoing and dynamic process between you and your advisor, which helps to minimize uncertainty and maximize the potential of future success.
Let us show you the fiduciary difference. Reach out today for a Second Opinion. You deserve to be sure you’ll have enough money for everything you need for as long as you live.