average vs real rate of return

I spoke to a lady the other day and for the sake of anonymity, we’ll name her Sarah.  Sarah went to a workshop seminar that was given by a fairly popular figure in the financial world. And I must say, I don’t always agree with his advice. In fact, oftentimes, some of things he says and the advice he gives is completely mind-boggling or, quite frankly, outright wrong.

However, I will admit that this particular individual has done a really good job in some areas. For instance, he not only has done a great job with helping people understand the downfalls of consumer debt, but has also encouraged people to not get into consumer debt in the first place. So he does get my kudos for being able to get quite a few people get on the right track with some of these issues.

The kudos stop there. Apparently, Sarah brought it to my attention that he was teaching something else, which then caused a lot of questions to arise. Her question to me was, “Where can I get a 12% rate of return per year on my investments?”

So I asked, “Where did you hear that you can get 12% per year?  Where do you think you would need to invest?  Do you think that’s a reasonable rate of return to base your retirement plan around?”  She told me that this gentleman said that over the long term you could expect to receive almost a 12% rate of return on your investments.

That really got my attention because if someone based their retirement plan upon receiving a 12% rate of return, this could potentially present quite a problem when retirement comes around.

According to Sarah, he apparently tells his followers to expect that they can achieve average returns of about 12% per year.  I think that’s quite a stretch!  This absolutely blew my mind.  What happens if you only get 10% not 12% for example?  How would that affect your retirement?  It would probably affect your retirement a lot more than you might think!

Here’s my guess on this…I can only suspect that for some reason he’s not looking at the compound annual growth rate but is looking at the average returns instead.

Oh boy. Watch out…

This is where you really need to be careful. If you ask me, the average annual return figure really isn’t that important. What is important, and I suggest it should be to you too, is the actual rate of return.

Let me give you an example to demonstrate the difference. Let’s say, for instance, you invested $50,000 in the stock market.  It could’ve been in a stock, a mutual fund, or an ETF—it doesn’t matter.  You invested $50,000 and then in the first year the investment does terribly.  It goes down 50%. You would then have $25,000.  Well, let’s say that next year the investment goes up 100%.  Now you have $50,000—right back where you started, right?  Here’s the thing though…

If you take -50%, which is the first year’s return, and you add 100%, which is the second year’s return, and then you divide that number by two, which is the number of years, you get the average rate of return as 25%.

Yes, it’s technically true to say that this particular investment averaged 25%, but the reality is that person actually started with $50,000 and two years later they had the same $50,000.

I want to caution people who are using this advice. Making sure that you understand the distinction between average rates of return and compound annual returns is huge.

If you expect a 12% annual rate of return now while you are accumulating money for retirement this could end up presenting a huge problem down the road.

Again, I’m not sure why a 12% rate of return is being suggested as something to rely upon.  And I don’t know if he is perhaps looking at average rate of returns instead of the compound annual growth rate as I suspect.

Either way, you need to be very careful.  Perhaps you can achieve a 12% compound annual growth rate over time. However, I don’t suggest you count on it.

Instead, be conservative in your assumptions. It’s better to have too much money than not enough!

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