How Wall Street Lies To You (Legally)
Submitted by Axios Capital Strategies on November 28th, 2020Average Return vs. Actual Returns
How many times have you looked at the average returns for a mutual fund or ETF (exchange traded fund), or perhaps a money manager? You know how it goes: you are shown the 1-year, 3-year, 5-year, 10-year, and “since inception” average returns. We all tend to make decisions based on historical returns even though we know “past performance is no predictor or guarantee of future results.” While this is generally a poor metric to judge a portfolio by, especially if it’s the only one being used, this post isn’t how to quantify and qualify different financial vehicles.
There’s another disclosure that’s usually overlooked. At the bottom, in fine print, is often some language like, “Actual performance may differ.”
Actual performance? Isn’t that what we were looking at?
Sadly, no. Average returns and actual returns are indeed different, and materially so. Let’s take a quick, if extreme, example to illustrate the point.
Assume you are looking at a portfolio’s history, and it advertises an annual average of 0% per year over the past 4 years. The year-by-year returns are as follows:
| Portfolio Return | |
|---|---|
| Year 1 | 50% |
| Year 2 | -50% |
| Year 3 | 50% |
| Year 4 | -50% |
Now, what is the annual average return? Zero, right? (50 + -50 + 50 + -50)/4 = 0. Right. This is called an arithmetic mean, just like you learned in middle school. This is also what mutual funds and money managers show you as their past performance.
|
Portfolio Return |
|
|
Year 1 |
50% |
|
Year 2 |
-50% |
|
Year 3 |
50% |
|
Year 4 |
-50% |
|
Average |
0% |
If we put $100,000 into this portfolio four years ago, and the average is 0% per year, then we would have $100,000 now, right? A reasonable person would presume this, since that’s what the literature, even prospectuses, advertise. Sadly, it’s trickier than that. Let’s track the dollar value changes with the same year-by-year returns, starting with the $100,000 opening value.
|
Portfolio Return |
End of Year Value |
|
|
Year 1 |
50% |
$ 150,000 |
|
Year 2 |
-50% |
$ 75,000 |
|
Year 3 |
50% |
$ 112,500 |
|
Year 4 |
-50% |
$ 56,250 |
|
Average 0% |
Actual Cumm. Return -43.75% |
|
If you have to spend a few minutes studying the difference, we understand. It seems like a brainteaser when you first learn the difference between average and actual returns. Even though the average return of this portfolio really is 0%, the actual cumulative return is -43.75%! Wall Street is not required to show you the actual returns, what the dollar amount actually grew (or declined) to. That is the definition of actual returns. What do you value more when evaluating a financial instrument? We thought so.
The actual return is called a “geometric mean,” and is much more telling when investigating financial tools, especially since it takes into account the effects of compounding. While this is an extreme example to illustrate the principle, the concept is accurately portrayed. Over time, even a difference of 1-2% between average and actual returns can mean a difference of tens to hundreds of thousands of dollars in your account value.
The next time you read the fine print and find the disclosure that “actual returns may differ,” just know that they almost certainly will differ, and that difference can be quite dramatic. Why does Wall Street only show us the average return in their material* Because it’s almost always higher than the actual returns of their products or portfolios.
Here’s a longer-term, less dramatic example.
|
Portfolio Return |
End of Year Value |
|
|
Year 1 |
10% |
$ 110,000.00 |
|
Year 2 |
-5% |
$ 104,500.00 |
|
Year 3 |
5% |
$ 109,725.00 |
|
Year 4 |
-10% |
$ 98,752.50 |
|
Year 5 |
20% |
$ 118,503.00 |
|
Year 6 |
-10% |
$ 106,652.70 |
|
Year 7 |
10% |
$ 117,317.97 |
|
Year 8 |
-15% |
$ 99,720.27 |
|
Year 9 |
15% |
$ 114,678.32 |
|
Year 10 |
-20% |
$ 91,742.65 |
|
Average 0% |
Actual Cumm. Return. -8.26% |
|
Even though there’s nearly a $9,000 loss over the ten-year example period, the average return, what you would see in the sales literature, is 0%. Forgive us, but even though this is “legal” to advertise as such, we can’t help but feel it’s misleading.
When Are Average and Actual Returns Equal?
When there are all positive years or periods, the average and actual returns match. When there are periods of no negative returns (but at least one 0% year, neither negative nor positive), then the actual and average returns are very close, bringing more transparent historical returns to the surface. This is one reason we usually advocate an absolute return strategy as opposed to a relative return strategy, especially with money that really matters . . . you know, like retirement money—money you have to make last rest of your life.
Happily, there are many retirement strategies that eliminate downside market movements in your retirement strategies while still participating in upward market movements, thus allowing your average and actual performance to come closer in alignment. After all, isn’t what the money actually grew to (actual return) more important that the arithmetic percentage average?
Yeah. It is.
Dig deeper when you look at historical performance numbers and you might be surprised.
