The Most Important Thing I’ve Learned About Money:
Real Rate of Return and Why It’s Not Used in This Industry
So let’s talk about money.
Pretend with me that you put $100,000 into mutual funds or stocks and it goes up by 50% in the first year. In the end of the year 1, your account would be worth $150,000 assuming no fees.
The next year is equally as bad as the first year was good, and it goes down by 50%. Well 50% of $150,000 is $75,000. So you go from $150,000 all the way down to $75,000. This is a full $25,000 loss from where you started at $100,000.
In the real world, you’re down 25%. But what are you averaging?
You are averaging 0% rate of return.
You went up 50% the first year down 50% the second year so +50% plus -50% / the two years = 0%. This is called the “mean” and you should if your Advisor is being “mean” or accurate on the reports that you get.
So any investment averaging 0% should be worth about what you originally put in right? But it’s not, its worth 25% less than what you invested.
What type of growth pattern would have to happen for the account to be about the same after two years? You put in $100,000 it goes up 50% to $150,000 in the first year – then only a 33% loss would take that $50,000 away from you and take you back down to the $100,000. So a 50% increase followed by a 33% decrease leaves you with exactly the same amount of money put in. Yet we are averaging a positive number?
A +50 plus -33% leaves us with 17% over 2 years so we are averaging 8 ½%, but we made no money. So you were making 8 ½%, yet your money wasn’t really growing. If you put $100,000 into an investment and it goes up by 50%, a 33% loss will take all of those gains away from you. So large gains can be taken away with smaller losses.
Well, what if we go in the other direction?
Le’ts say you put $100,000 into an investment, and it goes down by 50% in the first year. Now, you are at $50,000. And the next year it went up 50%.
50% of the new account size of $50,000 is $25,000. You’re back up to $75,000. Still down $25,000 but we are averaging 0%.
What rate of return or growth would we need to get from $50,000 back to our original $100,000? We need 100% growth to recover from a 50% loss!!! So over 2 years we have no growth but what are you averaging?
-50% plus +100% = 50% divided by 2 years
You’re averaging 25% per year.
Large gains can be taken away by smaller losses and small losses require much larger gains to get your money back and in both cases, YOU LOST THE MOST IMPORTANT ELEMENT OF COMPOUND INTEREST WHICH IS TIME.
So one thing you need to understand, the market isn’t good bad or indifferent but mathematically the odds are stacked against you. No matter which way it goes, if you make money a smaller loss can take it away, if you lose money, you need a bigger gain to make it back.
How much would it affect the amount of money you have in the Market if you discovered that when they say “The market has averaged 7-9% for the last _____ years” they are using the Mean rather than real growth?
For me, I think it’s the most important thing I’ve ever learned about money and the plans I design focus on Real Growth first then the market (gambling) second.