The Average Return Can Be Misleading.
Two portfolios can have the exact same average annual return and produce completely different outcomes for the investor.
“The stock market returns an average of 7% a year.”
That line gets thrown around a lot, but the number may tell you surprisingly little about how much money you actually made.
Consider two hypothetical investors. Each starts with $100,000 and invests for 12 years.
7% every single year.
Portfolio A earns 7% every single year—an unlikely outcome for an equity portfolio, but useful for illustration.
The arithmetic average annual return is 7%.
Now change the sequence of returns.
Portfolio B experiences a very different series of gains and losses:
Add those 12 annual returns together and divide by 12:
Exactly the same average annual return as Portfolio A.
Yet the investor in Portfolio B finishes with only approximately $94,007.
A 7% average can hide a lot of volatility.
Portfolio B's arithmetic average is 7%, but the experience behind that average includes several large gains and several very large losses.
Same starting balance. Same 7% average return. Two completely different outcomes.
Your wealth does not compound at the arithmetic average.
It compounds according to the actual gains and losses experienced by the portfolio over time.
The arithmetic average simply adds the annual returns together and divides by the number of observations.
But your money does not reset to $100,000 at the beginning of every year.
Each new percentage return is applied to the portfolio value that remains after all of the gains and losses that came before it.
Your wealth therefore compounds according to the geometric return—the actual compounded experience of gains and losses over time.
A loss requires a larger gain just to get back to even.
Percentage gains and losses are not symmetrical.
A portfolio that loses 50% does not need a 50% gain to recover.
It needs a 100% gain.
That is why large losses after strong gains can erase years of progress and significantly hinder long-term wealth building.
Follow the money—not the average.
Portfolio B initially grows dramatically faster than Portfolio A. By the end of Year 6, it has grown to more than $323,000. But repeated large losses eventually reduce the account below its original starting value.
The investor was winning—until the losses changed the math.
At the end of Year 6, Portfolio B is worth approximately $323,691—far more than Portfolio A at the same point.
Then comes a 50% loss.
The portfolio immediately falls to approximately $161,846.
Later, a 47% loss and another 50% loss further reduce the amount of capital available to participate in subsequent gains.
Average return does not tell you the whole story.
Portfolio A and Portfolio B both report an arithmetic average annual return of 7%.
But Portfolio A compounds steadily while Portfolio B experiences repeated large drawdowns.
Because your wealth does not compound at the arithmetic average of your annual returns. It compounds according to the actual compounded experience of gains and losses over time.
And when large losses follow strong gains, they can erase years of progress and significantly hinder long-term wealth building.
How much downside risk is actually hiding inside your portfolio?
With markets near all-time highs, this may be an especially important time to understand how much downside risk is actually inside the investments you own.
Strong markets can make risk easy to overlook. But as the example above shows, avoiding large losses can matter just as much as capturing gains.
Analyze Your PortfolioThis material is provided for educational and informational purposes only and should not be construed as individualized investment, tax, or legal advice or as a recommendation to purchase or sell any security.
Portfolio A and Portfolio B are hypothetical illustrations and do not represent the performance of any actual investment, account, strategy, or client. The examples assume the stated annual returns and do not include investment advisory fees, transaction costs, taxes, contributions, withdrawals, or other expenses that would affect actual results.
Past performance does not guarantee future results. Investing involves risk, including possible loss of principal. Arithmetic average return, compounded return, volatility, and drawdown measure different aspects of investment performance and should not be considered in isolation.