Dollars and Averages are Misunderstood

averages

Fred wanted to invest some money and decided that an “average” return of 5% over time would be a reasonable expectation. After all, he was told that the “average” returns over the last 25 years was 6%, and he wanted to be conservative in his expectations.

So, when Fred thought about how $100 would average a 5% return over 3 years, he imagined:

          $100, $105, $110.25, $115.76…perfectly compounding at 5%

Fred invested his $100.  After 3 years his investment advisor told him he averaged a 5% return.  Fred thought, “Great, right on target!  That means I have $115.76, right?”  “Well,” his advisor squeamishly said, “Not quite.”  When Fred asked to see his annual numbers, he was shown these:

          $100, $160, $80, $84

‘WHAT?!?,” Fred gasped.  “You said I averaged 5%.  Where’s my $115.76?” 

“Uh,” his investment advisor said as he slithered out of his chair, “My secretary is calling me, hold on.”    

Well, Fred DID “average” 5%.  Here’s how:

          $100 went up 60% = $160

          $160 went down 50% = $80

          $80 went up 5% = $84

                    So, +60% – 50% + 5% = +15%, divided by 3 years = +5%.

                    There you have it:  5%!

And further, Fred learned a very important lesson: Averages” do not translate into actual dollar values.  However, they are regularly used by financial advisors to discuss historic performance and, in turn, calculate future projections.

Game over.  Whenever anyone tells you they average 5%, 10%, etc., it means absolutely nothing.  Nothing!  “Averages” are wildly misleading, disguise historic volatility, and ignore future volatility.

As a side note, what the financial advisor used as “returns” was actually “change”. And that, boys and girls, is standard practice.

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