The Deception of Market Averages

Written By Aj Blackstone

The line “the stock market returns an average of 7% a year” gets thrown around a lot, but that 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.

Portfolio A – Portfolio A earns 7% every single year—an unlikely outcome for an equity portfolio, but useful for illustration.

Year 1: +7%

Year 2: +7%

Year 3: +7%

Year 4: +7%

Year 5: +7%

Year 6: +7%

Year 7: +7%

Year 8: +7%

Year 9: +7%

Year 10: +7%

Year 11: +7%

Year 12: +7%

Average annual return: 7%. After 12 years, $100,000 grows to approximately $225,219.

Portfolio B – Now consider a very different sequence of returns:

Year 1: +5%
Year 2: -2%
Year 3: +4%
Year 4: +49%
Year 5: +45%
Year 6: +40%
Year 7: -50%
Year 8: +35%
Year 9: -47%
Year 10: +32%
Year 11: -50%
Year 12: +23%

Add those 12 annual returns together and divide by 12…Average annual return: 7%.

Exactly the same as Portfolio A, yet the investor in Portfolio B finishes with only approximately $94,007.

  • Same starting balance.

  • Same 7% average annual return.

  • Two completely different outcomes.

Why?

Because your wealth does not compound at the arithmetic average of your annual returns. It compounds at the geometric return—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.

With markets near all-time highs, this may be an especially important time to understand how much downside risk is actually hiding inside your portfolio.

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.

AJ Blackstone

President

Aj Blackstone