When we are presented with the option to invest in a product, most of us want to know how much that particular investment will make us. Financial advisers generally use average rates of return so that they can predict how your money will grow into the future.
Career investment, not guaranteed either. Most of us know there is no such thing as a guaranteed rate of return. I invested $200k into my education and became a physician, taking my hourly wage from $10-15/hr to around $100/hr. It’s a good investment but that wasn’t certain either, I could have dropped out, burnt out, not made the grades or been kicked out that career track.
Some invest in real estate and have rates of return somewhere in the 8-12% range. Is that guaranteed? Nope. It’s still a decent return though some of my colleagues don’t find 10-12% all that impressive. If one couldn’t get at least somewhere close to that range then the hassle of real estate may not be worth it as it is a bit less passive than other investment options out there.
How about savings accounts, or CD? Remember back in the 80’s, CD rates were in the 8% range. Were those guaranteed? Well, yes, for a short period of time. But they certainly didn’t last.
It’s Easy To Predict The Market In the Short-term
Predicting the market when it’s hot or when it’s not. In a bull-market or during a real estate rally one can safely predict that for a couple of months-years investments on Wall Street will go up by 10% year after year. Who knows what will happen after that, maybe a stagnation, maybe a 25% drop in one year.
In a hot real estate market housing will rally, $500k homes will be worth $650k and rent prices will go up and our profit margins will increase. I know those returns will last for however long the real estate rally will last. The problem is I don’t know exactly how long that will be. So don’t be fooled by those who claim some investment is shit because it’s in the dumps and don’t let someone tell you something is hot because it just happens to be rallying.
Nothing Is For Certain But You Won’t Make Money Sitting On The Side-Lines
In the big scheme of things absolutely nothing is certain when it comes to investments. I keep repeating it because you don’t need a guaranteed return year after year to benefit from a certain investment. I don’t think Yahoo, AOL, MySpace or BlockBusters counted on disappearing with the changes in the economy. But does it mean that the investors and engineers and entrepreneurs of those companies should not have even bothered investing? Of course not.
Investing for the sake of learning about investing. Before I get back to Real vs Average returns I want to make another point. If you invest, whatever the hell you decide to invest in, you will learn about your money – that’s for certain! You will make mistakes and you will have bad moments followed by great moments. It’s a long-term game and the scene will always be changing. The more you invest the more you will learn and in this economy it’s hard to survive if you aren’t willing to change with the times.
Forgoing Investing – Keeping It All In Cash
I don’t think putting all your money in gold/silver or cash is viable. It could be a viable strategy for a select few, but it won’t be easy nor safer than investing. If you decide on such a system because you don’t want to take a risk well then let me pose this question to you, what about the risk of inflation? Or hyperinflation?
Markets fluctuate a lot but in the end those markets will stop existing if they can’t return a decent income for the investors – supply and demand. Could a time come when mutual funds will be obsolete, sure it’s possible. But it won’t happen in isolation. When mutual funds disappear so will stocks and bonds which means that large businesses will no longer exist and we would shift towards many mom & pop businesses. Then perhaps only peer-to-peer lending will exist.
Defining Real and Average Returns
The REAL rate is the addition and subtraction of all the ups and downs of your investment over a time-period you define. So if you start with $100k and end up with $105k a year later then your real rate of return was 5% for that year.
An actual example would be my VGSLX investment. For the past 2.5 years I have earned a real rate of return of 5% or $948. The fund however has managed a rate of return of 15%+ over the past 5 years and 6%+ over the past 10 years. So one could say the average rate of return for this fund is somewhere in the 6% range since 10 years is fairly long enough to give us a realistic view. Imagine if we used a 5-year mark instead, well shit, I greatly underperformed the average in that case.
So the AVERAGE rate of return is what an investment has returned over a certain amount of time, averaging out the ups and the downs. If one calculates this based off of 3 years it will be different than if a 5-year or 10-year window is used. The point it is that this average value is a bit more subjective.
This cute little spreadsheet from the IFC website does an amazing job of showing you the difference between average and real returns. It shows that you can start with $100k and end up with $94k and have a real return of -6% but an average rate of return of +25% because the average rate of return takes into account how you got to the final amount while the real rate of return only cares about how much you gained or lost.
Why Should You Care?
The reason I wanted to write this post is because anyone can make the argument that one method should be used over the other. In reality the only thing that should matter to you is the real return. But you won’t know that because that’s a future-facing value. The best way to ensure a good rate of return is to understand the investment and that should give you the best way to “predict” it’s foreseeable long-term performance.
If you look back at your last 10 years of real estate investing and you had 3% of actual (real) returns then you are probably doing something wrong because the “going rate” or the average is higher for that. So you see, the average is helpful because it allows us to have a point of reference.
We must use the average rate of return for practical reasons but you better be careful who is quoting that value to you. A crappy junk bond might have an average rate of return of 10% over a short period of time but have a -20% over a more representative timeframe.
Get Your Information From The Right Source
A professional adviser will likely give you an average value that’s believed to be what’s capable and likely of such an investment. Of course that is no guarantee. It will be up some years and down others. In the end you can expect to have that said average rate of return – that’s what an average rate of return is.
What you should take away from this post is that whatever investment you choose will have some ups and some downs. But over a long enough time-frame most sound investment categories will yield their predicted returns.
As you get closer to your retirement you will convert more and more of your money into cash equivalents (bonds, cash savings, CD’s) depending on how many years you’ll be spending in retirement. Converting to cash decreases the volatility of your money. Until that time you are better served letting your money grow no matter which rate of return you want to focus on, real vs average.
Focus on diversifying and realize that even if you want to be mostly in cash you pretty much have to have some exposure to more traditional investments unless you want to be an all out entrepreneur. As an entrepreneur you believe in creating your own rate of return, a real return based on sweat-equity.
Diversify To Control Risk And Increase Growth Potential
By diversification I mean to have some money in stocks, some in bonds, some in savings and some in real estate. You can have some money invested in your own business, some money invested back in yourself (your skills) and some money to experiment with.
If you don’t think Wall Street is for you or you have a moral issue with it at least consider dabbling in it. By having some exposure you are likely to improve your skills. Same is true for real estate, to which you can gain exposure through individual purchase of properties, creating rental income, flipping homes or through REITs.