The Average Return “Lie”

What investment companies and financial entertainers don’t tell you could cost you thousands.

Investment companies and financial entertainers like Dave Ramsey & Suze Orman talk about getting a 12% average return in from mutual funds but is that real? Does that actually happen in the real world? There is an old Yiddish Proverb that says A Half Truth is Still a Whole Lie. The average return “Lie” is one of the most important lessons that someone saving for retirement can learn.

I am not saying that any one person or company is specifically lying. What I am saying is that financial companies and financial entertainers often fail to give the whole truth by leaving out key pieces of information. Consider the following question. When is a 12.5% rate of return NOT a 12.5% rate of return? Is it possible for a person to get a 12.5% average rate of return and end up with much less? Yes and here’s how it works.

Let’s start with $100,000 and assume a 1% fee. If you average your return of 12.5%, at the end of year 1 with a 50% gain your balance would be $150,000. After the fee it’s $148,500. At the end of year 2 with a 25% loss, your balance would be $112,500. Subtract your fee and its $110,261. At the end of year 3 with a 50% gain, your balance would be $168,750 and at the end of year 4 with a 25% loss, your balance is $126,562. After your fees, your balance is at $121,575.

Based on these numbers, your actual average return is 6.07% and after your 1% fee, its only 5.01%.

The problem with the half-truth of an average rate of return is that it does not work the same when you add real world factors. Simply totaling up the annual rates of return and dividing by four yields a misleading number. In this example, the Real Return after fees is 60% lower than the average.

Applying those percentages to real numbers and accounting for the time factor and fees yields a very different outcome. If we include the cost of taxes and inflation, the real rate of return would be even lower.

Real World factors to consider:
· Most people do not put in $100,000 into an account all at once and leave it untouched for 20 years.
· The investment world teaches us to invest systematically on a consistent basis. Automated payroll deductions is the most common way that people save. When we
invest periodically, our money is not “all in” when the market falls or goes up.
· Real people do not put in the exact same amount of money for the entire period of time. Our investment amounts often change over time as our income rises or as we
get closer to retirement.
· We have all heard the expression that “nothing in life is free”. It goes without saying that real people cannot invest for free. There is always some cost incurred in an
investment. If this were not the case, Wall Street would be a ghost town.
· Real people pay taxes. If we accounted for taxes in the figures above, the real rate of return would be much lower.

Why is the gap so large? In simple terms, the combination of real world factors makes the down years worse and holds back the gains in up years.
Understanding these truths is a big part of being more in control of your retirement plans.

Kraig Strom, CFP®, ChFC® is a Certified Financial Planner® and owner of WealthyCastle.com. He can be reached at 877-297-5851 orwww.WealthyCastle.com.