What does Average Rate of Return mean? Average Rate of Return is a math calculation. It is designed to be a measure of an investment's profitability or loss over a period of time.
How do you calculate Average Rate of Return? You take the sum of each year's actual rate of return and divide the total amount by the number of years. Assume the fund has been in existence for 2 years and the rate of return for each year has been 10%. The sum of the two years is 20%. 20% divided by 2 = 10% average rate of return.
Why is Average Rate of Return misleading?
Average rate of return has nothing to do with the amount of money that is in your account. Average rate of return is a math calculation not a money calculation.
For example - You invest $100 into your favorite Mutual Fund. The fund has a great year and returns 100% the first year. You currently have $200 in your account. The second year rolls around and it doesn't perform nearly as well. You lose 60% of the value in the account or $120.00. That leaves you $80 in your account.
A gain of 100% and a loss of 60% gives you a net gain of 40% over the two years. The average of 40% over the two years is 20%.
Average Rate of Return is calculated using this method.
You add each year gain or loss and divide it by the numbers of years the fund has been in existence. $80 in your account is not a gain of 20%. The money you lost was $20. The actual rate of return was a -20%.
Many of the financial institutions display the returns in their annual reports in this manner.
The Math
Year 1 $100 + 100% (gain) = $200
Year 2 $200 - 60% (loss) = ($120)
Balance $80
Average Rate of Return calculation
100% + (-60%) = 40% divide 40% by 2 = 20%
Dow Jones Industrials (1931 -1950)
Had you invested in a Dow Jones Market Index during this 20 year period your Average Annual Rate of Return would have been 5.26%. The Actual Rate of Return was 1.81%. $100,000 invested at the end of 20 years was worth $143,154 (assuming no fees). The Average Rate of Return (5.26%) would lead you to believe there was $297,357 in your account. More than double the actual amount.
Refer to the reported numbers and skip reviewing the annual rate of return.
You might want to do a little more digging the next time you are reviewing a report from a financial institution. The 20% being touted might be a big loss. Ask for the actual dollar amount and do your own calculation on actual rate of return.
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