In view of the decades of market upswing, the recent downturn, you may have questions about whether your money is really working for you. For example, is it possible to earn an average return of 25% and still not make any money? The answer is yes!” Stay with me for a math lesson in returns.
Understanding the simple truth that math isn’t money can help you move away from a passive pursuit of retirement where you only half understand what’s going on — especially with all the bad news you might be into a state of constant panic one that is actively pursuing your retirement goals and putting you in the best position to achieve them.
A recently American Psychological Association survey (opens in new tab) found that money-related issues are the number one source of stress for most Americans, ranking above worries about work, family responsibilities, and even health.
Like me, you have nothing against financial companies, but they can use math to skew the numbers in their favor to make things appear better than they really are. The average return on an investment is that mathematics Part of the situation, but it doesn’t necessarily translate into money in your pocket, which is what we all want after all – it pays the bills, buys groceries and covers medical expenses. We look at averages when investing to provide a kind of beacon on which to base our best investment decisions.
To help you understand the concept that math isn’t money, I’ll start with a hypothetical example using extreme numbers in four different time periods. I’m going to use two bull markets and two bear markets, so the results are obvious.
So a hypothetical return of 25% is not equal to money
Meet Tom and Debbie. You have $100,000 to invest and you have a four-year time frame. You are open to growth and take some risk. Tom and Debbie know they need to grow that money to reach their retirement goals. You meet one financial professional and review different portfolios and choose a portfolio that has a historical track record of delivering an average return of 25% over the allotted time.
At the beginning of the first period, Tom and Debbie start with $100,000 and experience a bull market. You earn a 100% return during this period. This gives them a $100,000 return on their investment – pretty sweet. At the end of the first bull market, they have $200,000.
You are starting your second period with $200,000, but they’re in a bear market and they’re taking a 50% loss on their investment. You lose $100,000 of your $200,000. This gives you a final balance of $100,000.
You are starting your third period with a balance of $100,000 and seeing a bull market. They earn a 100% return on their investment, which translates to a $100,000 profit ending the third period with a total of $200,000 – much better.
They are beginning their fourth period with $200,000 and experience another bear market where they lose another 50% of their money, lose $100,000 and end this period with $100,000 in their account.
If you look at the math in these periods, Tom and Debbie gained 100% in each of the bull markets (periods one and three) and lost 50% in each of the bear markets (periods two and four). Let’s do the math: 200% gain minus 100% loss = total gain of 100%. If you divide that 100% gain by the four time periods, you get an annual average return of 25%: 100% gain divided by four time periods = 25% average return. That’s math!
Let’s check the money: They started with $100,000 and ended up at $100,000 after four different markets, so their actual return was ZERO, right? And that’s the difference between math and money.
The big lesson is that math doesn’t equal money in your pocket.
A return is still not the same as money
Let’s see how this concept plays out in real life. If you examine the average return of the S&P 500 from 2000 to 2014, you can see that average returns don’t tell the whole story of real money in Tom and Debbie’s pocket.
If Tom and Debbie started with $100,000 in 2000 and grew that account over the next 15 years (to 2014) using the total return of the S&P 500 Index, they would have an account balance of $186,430. Adding up gains and losses every 15 years gives you 91.38%, and dividing that total by the 15 years gives you an average return of 6.09% per year.
Let’s test the math to see if the actual account balance matches the average return. I run a future value calculation that adds 6.09% to their $100,000 deposit each year. When I do that, her balance is not $186,430, it’s $242,726. That’s a 30% difference between the two balances! The S&P 500 return may be mathematically correct, but it’s not the reality Tom and Debbie expect to see in their pocket where it matters.
Living and dying by market averages is up to you timed coordination, exit the market on the highs and invest on the lows… but it’s impossible to predict the future! This strategy doesn’t net you the money you expect. If Tom and Debbie started with $100,000 and ended with $186,430 over a 15-year period, that’s an actual return of just 4.24%. The conclusion is that while the S&P 500 index averaged 6.09%, the actual return is only 4.24%, again proving that math isn’t money.
Math is not equal to money: the snack bar
It’s very important that investors and savers like Tom and Debbie understand the difference between an average return and the actual return on their own investment. If you or your financial professional use forecasts Average return vs. indeed returns, this can result in a 30% difference between what was forecast for you and your account value when it’s time to retire.
bottom line: Math is just a number while money is something to take home. It’s what buys the groceries, sends kids and grandkids to college, covers your medical bills — it’s the security of your lifestyle.
From this day forward, I hope you understand this and live by it: average returns should not be considered when your life security could be at risk. Unknown forces are always at work in the financial markets, and no one can predict when the next meltdown or “market correction” will occur.
The last thing you can afford is to interrupt the compounding effect of our retirement money when it’s finally time to pursue your dreams and enjoy retirement. Hoping for the best won’t work. Gaining clarity about the reality of your approach by understanding this principle could be a step in that direction Dealing with your expectations and make sure you achieve the retirement you want.
Questions to ask your advisor to clarify the plan
Ask your financial advisor these questions for clarity:
- When making forecasts, can you use an actual return versus an average?
- What is a realistic payout rate I can count on when it comes time to supplement my retirement cash flow with withdrawals from my investments? And how do you know that?
- I noticed that your prediction(s) indicate I have an X% chance of success. What happens if I don’t succeed? What is the contingency plan?
- What if the market is in a bear or corrective state when I retire? How does this affect the cash flow we can draw from my portfolio?