Investment Planning Edition Episode 7 - The Deceptive Average: Why Your 8% Return Doesn’t Equal 8% Growth
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Phani Kandula
Show Notes
The Deceptive Average: Why Your 8% Return Doesn’t Equal 8% Growth - Show Notes
Resolving the contradiction between marketing math and actual wealth with "Honest Averages"
Quick Episode Summary
Have you ever looked at an investment statement boasting an 8% or 10% "average return," only to find your actual account balance hasn't grown by that amount? You aren't crazy, and your calculator isn't broken. In this episode, we dismantle a common financial contradiction: the gap between the "math" on the page and the "money" in the bank. We explore how volatility erodes wealth through "volatility drag," explain the critical difference between Arithmetic and Geometric means, and provide a Sound framework for reading your statements with a detective's eye to find the honest number that truly matters for your retirement planning.
SafeSimpleSound Framework Featured
- Primary Principle: Time Coexistence (Using both averages simultaneously to understand different aspects of the portfolio).
- S3 Characteristic Emphasis: Sound (Focusing on the "Honest Average" / CAGR that creates actual long-term wealth stability).
- Contradiction Resolved: The "Either/Or" Dilemma of the Flattering Average (looks good) vs. the Honest Average (feels bad) is resolved by using one to measure risk and the other to measure wealth.
Who This Episode Serves
- Diligent Savers & Pre-Retirees: Individuals who feel a disconnect between the "average returns" promised in brochures and the actual growth of their nest egg.
- Retirement Planners: Families moving from accumulation to distribution who need to know if their retirement income plan is based on flattering marketing math or sound reality.
- Math-Averse Investors: People who feel intimidated by financial jargon and want a Simple explanation of how compounding actually works during volatile markets.
What You'll Learn
- Distinguish between the "Flattering Average" (Arithmetic Mean) and the "Honest Average" (Geometric Mean/CAGR).
- Identify "Volatility Drag" and understand how the ups and downs of the market erode your compounding principal.
- Apply a "Both/And" mindset to use simple averages as a "volatility meter" rather than a growth projector.
- Evaluate investment opportunities with a "Sound" perspective by looking past big bold numbers to find the Compound Annual Growth Rate.
Key Topics & Concepts
Primary Focus: Understanding Investment Returns & Volatility Drag
Concepts Covered:
- Arithmetic Mean (The Flattering Average): A simple calculation (+50% minus 50% divided by 2 = 0%) that treats each year as an independent event, often masking losses.
- Geometric Mean / CAGR (The Honest Average): The Compound Annual Growth Rate; the constant rate of return required to get from a starting balance to an ending balance.
- Volatility Drag: The mathematical reality that volatility (big swings up and down) pulls your actual realized return down below your average return.
- Time Coexistence: The S3 principle of using multiple metrics simultaneously to get a complete picture of the "ride" vs. the "destination."
Professional Authority Elements:
- Application of ChFC® (Chartered Financial Consultant) standards to ensure income plans are built on "Honest Numbers."
- Utilization of the SafeSimpleSound methodology to move clients from confusion (contradictory numbers) to clarity (understanding the function of each metric).
Stakeholder Value Creation:
- For Clients: Protects retirement plans from running out of money due to inflated growth expectations.
- For Prospects: empower them to audit their current statements and ask harder questions of their current advisors.
Episode Breakdown
Opening: The Disconnect
- The Contradiction: The "Math" says average returns are high, but the "Money" says growth is low.
- The Safe Message: This is not a personal failure or a calculation error; it is a misunderstanding of how "average" is defined in finance.
- The Foundation: To understand the disconnect, we must strip away Wall Street jargon and look at the mechanics of compounding.
The Mathematics of Volatility
Insights:
- The $100 Example: A portfolio that goes up 50% in Year 1 ($150) and down 50% in Year 2 ($75) has a "Simple Average" of 0%, but an actual loss of 25% of wealth.
- Arithmetic Mean: This is the "Flattering Average." It ignores the sequence of life and the fact that losses are applied to larger principals or gains to smaller ones.
- Geometric Mean: This is the "Honest Average" (CAGR). In the example above, the honest average is -13.4%, which accurately explains why you only have $75 left.
Both/And Solutions Demonstrated:
- We don't have to choose between "Is the advisor lying?" or "Am I bad at math?" We acknowledge that both numbers exist but measure different things.
The Real World Application: The Millers
Scenario:
- A pre-retirement couple expects $730,000 based on an 8% "Average Return."
- Due to high volatility, the actual compounded growth is only 5%.
- The Result: They arrive at retirement with $638,000—a nearly $100,000 shortfall.
- The Lesson: Marketing brochures report the Arithmetic Mean (Flattering) without explaining Volatility Drag. Sound planning requires using the Geometric Mean to forecast retirement dates.
The Solution: Time Coexistence
Insights:
- We use Both averages to gain richer understanding.
- Arithmetic Mean = The Ride: Use this as a "Volatility Meter." A high simple average with low actual growth indicates a very bumpy, risky ride.
- Geometric Mean = The Destination: Use this to measure actual wealth building and effective compounding.
Closing: Evolution & Empowerment
- Be a Detective: Look past bold numbers in marketing materials.
- Embrace the Tortoise: Lower volatility portfolios (even with lower simple averages) often produce more money because they suffer less volatility drag.
- Victory: Understanding this distinction is a victory for financial literacy and Safe confidence.
Practical Resources
Self-Reflection Questions
- Vision-First Direction: When I look at my financial goals, am I planning based on the "Flattering Average" (marketing hope) or the "Honest Average" (mathematical reality)?
- Practical Application: Look at my most recent investment statement. Is there a gap between my "Average Annual Return" and the actual growth of my account balance?
- Risk Assessment: If my portfolio has a high "Average" but lower growth, am I taking on more volatility risk than I realized?
Examples & Scenarios
[The $100 Volatility Test]
- Situation: You invest $100.
- Year 1: +50% Return. Balance grows to $150.
- Year 2: -50% Return. You lose 50% of the $150 ($75 loss). Ending balance is $75.
- The Math Trap: Simple Math says (+50 - 50) / 2 = 0% Average Return.
- The Reality: You lost 25% of your money.
- Key Takeaway: Avoiding large losses is mathematically more important than capturing huge gains. This is the definition of Sound investing.
Implementation Guide
If you want to apply these constitutional insights to your portfolio:
Step 1: Be a Detective. When reviewing fund fact sheets or statements, ignore the big bold "Average Return" initially.
Step 2: Find the Truth. Look for the "Compound Annual Growth Rate," "CAGR," or "Annualized Return" (often in footnotes).
Step 3: Embrace the Tortoise. Recognize that a strategy with lower volatility helps close the gap between your average return and your actual wealth.
Resources & Tools Mentioned
- Blog Post: "The Deceptive Average" (Available at SafeSimpleSound.com) – Contains visual graphs of the math discussed.
- Metric: Compound Annual Growth Rate (CAGR) / Geometric Mean.
- Metric: Arithmetic Mean (Simple Average).
Key Quotes & Insights
"It is a frustrating financial contradiction: The 'math' says one thing, but your 'money' says another."
"The simple average can be dangerously misleading because it ignores the impact of volatility on your compounding principal... It ignores the sequence of your life."
"The Honest Average answers the question that actually matters to your family: 'What was the constant, steady annual return I would have needed to get from my starting balance to my ending balance?'"
"The wider the gap between your Simple Average and your Compound Growth, the more risk you are taking."
Professional Authority
S3 Methodology Demonstrated
- Safe Foundation: Validates the investor's confusion ("You are not crazy") and prioritizes protecting the nest egg from deceptive math.
- Simple Application: Demystifies complex statistical concepts (Arithmetic vs. Geometric mean) using a clear "$100/Two Year" story.
- Sound Strategy: Advocates for long-term planning based on "Honest Numbers" (CAGR) rather than marketing fluff to ensure retirement funds last.
Competitive Advantages
- Both/And Thinking: Unlike the industry that forces you to choose between "good returns" or "safety," S3 uses the Simple Average as a risk tool and the Honest Average as a planning tool—integrating both for better decision-making.
- Educational Generosity: Provides the exact "detective skills" needed to audit statements, empowering listeners regardless of whether they become clients.
Additional Learning
Related Topics
- Sequence of Returns Risk: How the order of returns impacts retirement income (closely related to volatility drag).
- Risk Capacity vs. Risk Tolerance: Understanding how much volatility your financial plan can mathematically handle vs. how much you can emotionally handle.
- The Distribution Phase: Why volatility matters even more when you are withdrawing money in retirement.
Further Reading/Learning
- Article: "The Deceptive Average" at SafeSimpleSound.com.
- Concept: Explore "Standard Deviation" to further understand how "The Ride" is measured.
Connect & Continue the Conversation
Connect with SafeSimpleSound
- Website: SafeSimpleSound.com
- Email: hello@safesimplesound.com
- Social Media: LinkedIn Profile
Listener Engagement
We'd love to hear about your journey:
- Have you ever felt "betrayed" by a brochure that promised high returns that didn't materialize?
- When you look at your current portfolio, is the "Ride" (volatility) worth the "Destination" (actual growth)?
- How would planning with "Honest Numbers" change your retirement timeline?
Professional Services
At SafeSimpleSound, we build financial plans on a foundation of reality, not flattering projections. If you are tired of the confusion caused by misleading metrics and want to look "under the hood" of your financial plan with a ChFC® perspective, we invite you to explore our Safe, Simple, and Sound planning practice. We help families close the gap between their expectations and their actual wealth building.
DISCLAIMER: This content is for educational purposes only and should not be considered personalized financial advice. Always consult with a qualified financial professional before making financial decisions.