The Deceptive Average: Why Volatility Skews Your 'Average' Investment Return
Have you ever looked at your investment statements and felt a sense of disconnect? On one hand, you calculate the "average" annual return over a few years and it looks pretty good. But when you look at your actual account balance, the growth doesn't seem to match up. It’s a frustrating financial contradiction: "My average return is 10%!" versus, "Why do I have less money than that suggests?"
This isn't a mistake in your math; it's a misunderstanding of what "average" truly means in the world of compounding. Just as we learned in our last post that ‘real return’ tells a truer story than ‘nominal return,’ today we’ll uncover another layer of truth. The solution isn't to pick one number and ignore the other. Instead, through a sound, constitutional approach, we can resolve this contradiction by understanding that we need both a flattering average and an honest one to tell the complete story of our financial journey.
The Story of Two Years: A Simple Truth
Let’s set aside the complex jargon for a moment and tell a simple story. Imagine you invest $100 in a portfolio.
- Year 1 is fantastic: You earn a 50% return. Your $100 grows to $150.
- Year 2 is challenging: You suffer a 50% loss. Your $150 is cut in half, leaving you with $75.
Now, what was your "average" return? A 50% gain and a 50% loss seem to average out to 0%, right? But you didn't end up back at your starting point of $100. You ended up with $75—a 25% loss.
This simple, unforgettable example reveals a profound truth about investing: the simple average can be dangerously misleading because it ignores the impact of volatility on your compounding principal. This is the core reason for the disconnect between your calculated "average" and your actual wealth.
The Arithmetic Mean (The Flattering Average)
The simple average we calculated above (+50% and -50% = 0%) is officially called the arithmetic mean. It’s easy to calculate and not entirely useless. It gives you a quick snapshot of the yearly returns you experienced. It tells the story of the volatility of your journey—in our example, it was a wild ride.
However, for measuring your actual progress over time, it’s a flawed and often overly flattering narrator. It treats each year’s return as an independent event, completely ignoring that a 50% loss in Year 2 was applied to a larger starting amount ($150) than the 50% gain in Year 1 (which was applied to $100). This is where a more sound, time-tested principle is needed.
The Geometric Mean (The Honest Average)
If the arithmetic mean tells the story of the ride, the geometric mean tells you the actual result of the journey. It answers a much more important question for an investor: "What was the constant, steady annual return I would have needed to achieve to get from my starting balance to my ending balance?"
In the financial world, you’ll more commonly see this referred to as the Compound Annual Growth Rate (CAGR). It is the honest, constitutionally sound measure of your true investment growth because it fully accounts for the effects of compounding and volatility over time.
For our two-year example, the CAGR isn't 0%; it's -13.4%. If you had lost exactly 13.4% each year for two years, you would have ended up with the same $75. This number is less flattering, but it is undeniably more truthful. As a Chartered Financial Consultant® (ChFC®), my professional training emphasizes this distinction as a critical standard for accurate client communication. A sound financial plan must be built on the bedrock of honest numbers, not convenient ones.
Integration Over Abandonment: A Both/And Solution
So, should we abandon the simple average altogether? Not at all. The constitutional principle of Time Coexistence teaches us to respect and integrate different truths rather than force an either/or choice. We don’t have to choose between the flattering average and the honest one; we can use both to gain a richer understanding.
- The Arithmetic Mean tells you about the volatility you endured. A large gap between your arithmetic and geometric returns is a mathematical signal that your portfolio experienced a lot of ups and downs.
- The Geometric Mean (CAGR) tells you about your actual destination. It is the single most important number for understanding your true, wealth-building progress.
This is a perfect example of a both/and solution. We can say, "I understand the simple average shows my yearly return experience, and I use the CAGR to measure my real compounded growth." This integrated view provides constitutional confidence, freeing you from the confusion caused by misleading metrics.
How to Apply This 'Sound' Principle to Your Own Statements
This isn't just a theoretical exercise; it’s a practical tool for becoming a more informed investor. When you review your portfolio's performance or look at marketing materials for a mutual fund, be a detective.
Look for the long-term performance numbers. A fund might advertise a high "average annual return" (often the arithmetic mean), but the number that truly matters is the Compound Annual Growth Rate (CAGR). This sound principle protects you from misleading claims and helps you evaluate your own progress with clear-eyed honesty. This steady, tortoise-like approach to understanding your finances builds a much safer foundation than chasing flattering but illusory returns.
Ultimately, embracing the "honest average" is about building your financial life on a foundation of reality. It reflects a commitment to sound, time-tested wisdom—the kind that doesn't just look good on paper but actually translates to real, tangible growth in your life.
Look at a 3- or 5-year period in your portfolio. Calculate the simple average and then search for the 'Compound Annual Growth Rate' (CAGR). Which one tells a more realistic story? If you'd like a partner to help you read between the lines of your statements, let's connect.
This post is part of our Investments True Return Series.
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.