Myth: When evaluating your investments, a higher average rate of return always means you will have more money in the future.
Fact: It’s possible to have more money making 5%/year than making 20%/year.
I didn’t believe it at first, either. It seems nonsensical. I built my own spreadsheet to duplicate what I had read to make sure I wasn’t losing my mind.
How is this possible? The average does not tell you in what order those returns happen. That order can make a huge difference, as you can see in the chart below that shows what happens when you invest $10,000/year while earning differing rates each year:
You can see that a 10% average rate of return could mean you have $32,760 or you could have $39,360. A negative return in Year 1 for the 5% rate hurts less than the large negative return in Year 3 for the 20%. This concept, called the sequence of return risk, demonstrates that a great rate of return can be a mirage.
- I understand the positive rush of seeing an increasing account balance. I understand the disappointment when the balance drops. But, the truth is that daily, weekly, or even monthly performance means little to your ultimate success.
- Ignore investment products or advisers that brag about their rates of return. It does not tell you if you will make more money, nor does it tell you how much risk they take to try and achieve the returns.
- A constant focus on the stock markets often creates more desire to “do something”. Why do you think TV and the media use fear and greed to keep your attention? The short-term noise is useless information. Spend time on what you can control, and enjoy life more.
Tell a friend who fancies themselves good at math that you can prove that 5% can be better than 20%, show them this, and watch their brain melt!