It’s easy to look at an investment’s average rate of return and assume that your return on investment will be close to that number year after year.
But that’s not how the market works.
It experiences ups and downs that can take investors on wild rides that are important not to overlook while thinking about average investment returns on the surface.
But when you dig a little deeper, your real return differs —and that’s what matters because it determines your future purchasing power, ultimately the goal of investing rather than consuming assets (spending) now.
Let’s take a closer look at how it works and what returns you should be paying attention to.
Thinking of investment returns as “average returns” can be misleading.
The average return simply represents the mathematical average of an investment’s percent change each year; it doesn’t necessarily reflect investment gains or losses.
To see an investment’s gains or losses, you need to look at its annualized return, which computes the annual compounding change in investment value during a specific time period.
Here’s how it works.
Let’s say you have a $100,000 investment that increases by 50% in year 1 and decreases by 30% in year two for an average return of 10% per year.
Sounds good, right?
But if you do the math, you’ll see that the value of your original investment has only gained a total of 5% over two years.
Here’s why.
After increasing by 50%, your investment would be worth $150,000 at the end of the first year.
But then it decreases by 30% in year two, making it worth $105,000—representing an investment gain of just 5% or $5,000.
Now, let’s say the same $100,000 investment has a 10% annualized return over that same two-year period.
After a 10% gain in year one, it’s worth $110,000. Add in another 10% gain in year two and your initial investment grows to $121,000—representing a 21% or $21,000 gain.
You have the same 10% average rate of return in both scenarios but much different outcomes in investment growth due to differences in volatility. The less volatile an investment, the closer the average return and annualized return. Another way to think about it, volatility reduces the compound growth of comparable average returns.
That’s why it’s crucial to plan for market fluctuations from the start when evaluating investment opportunities and determining asset allocation.
Doing so allows you to ride out the ups and downs of the market—even when market returns are disappointing—while keeping your portfolio on track to achieve your long-term financial goals.
But your investment gains are just one piece of the puzzle when calculating investment performance.
It’s also crucial to consider inflation and how it can affect your future purchasing power.
Nominal returns may look good (or not so good) on investment statements —they’re the change in investment value from the investment price to the market value.
But real returns are what matter. They are a reflection of how much value the portfolio has generated, relative to inflation.
Here’s an example that illustrates the difference between the two and why it matters.
Scenario 1: You invest $100,000 today. In ten years, your investment is worth $259,000—an annualized return of 10%.
Scenario 2: You invest $100,000 in today’s dollars, and 10 years from now it’s worth $216,000—an annualized return of 8%.
At first glance, Scenario 1 looks like the better outcome. But those numbers don’t tell the whole story.
To understand the real value of your investment and the impact of the investment gains, you need to know what inflation looked like during that 10-year period.
Let’s revisit the example above.
Scenario 1: There was a 6% annualized inflation rate, resulting in an annualized real return of 3.77% and an increase in purchasing power of 45% relative to your original investment. That means for every $100 you invest (rather than spend) in year 1, you would need to spend $179 for the same spending power 10 years later, with an additional $80 excess generated from investment gain.
Scenario 2: Inflation hovered around a 2% annualized rate, bringing the real return on your investment to 5.88% and increasing your purchasing power by 77% relative to your original investment. That means for every $100 you invest in year 1, you would need to spend $122 for the same spending power 10 years later, with an additional $94 excess generated from investment gain.
Despite earning a lower annualized return in Scenario 2, your investment is worth more than in Scenario 1 because inflation was lower.
That’s why it’s important to think about your investment in terms of your real return, not the nominal return. This can be challenging to consider, as we’re perpetually evaluating portfolios in present-day values, but it’s useful to adjust return expectations for inflation when reviewing investment returns over a period of time.
If you had a balanced portfolio of stocks and bonds over the last 15 years, your nominal investment returns were probably lower than the historical annualized returns of comparable asset allocation portfolios.
Why?
Interest rates hit historic lows after the Great Financial Crisis of 2008, keeping bond yields low until inflation increased in 2022.
Lower bond yields “dragged” down nominal investment returns in portfolios with bond holdings for more than a decade.
But that’s only part of the story.
Because inflation was so low during that time period, real returns were much stronger than nominal returns indicate, as cost of living increases were relatively modest.
If you fast forward to 2022-2023 when inflation heated up, bond yields returned to historic norms, increasing the nominal returns of balanced investment portfolios.
Again, the more important factor to consider is the real returns.
When you see interest rates for high-yield savings accounts (HYSA) hovering around 4%-5%, it’s easy to get excited about parking cash in a HYSA—especially after more than a decade of significantly lower rates.
But when you’re holding cash, it’s crucial to evaluate interest rates relative to inflation.
That means if you had cash in a HYSA earning 5% in June 2022 when inflation hit 9.1%, the actual value of your money was decreasing, a negative real return.
On the flip side, as inflation cools, the return earned on cash in a HYSA may exceed inflation despite earning a lower interest rate.
For example, if inflation is 2%, and you’re earning 3%, that’s a real return of 1%.
While it’s understandable to look at the annual average return of your investments and assume you’ll achieve similar results every year, it’s not realistic.
If you look at past performance of the stock market, you’ll see that it’s not consistent from year to year—and the future performance we should expect to be just as inconsistent and volatile.
Long-term investors need to understand that market downturns aren’t a matter of “if” but “when.”
If you’re investing for the long-term you should expect to achieve below-average returns about half the time—and some years will be well below the average.
That doesn’t mean there’s anything wrong with the market or your investment decisions. It means the market is doing what we expect it to do. The volatility (risk) is rewarded with greater expected returns than assets with little-to-no risk.
Proper portfolio diversification based on risk tolerance and an understanding that volatility is to be expected can make it easier to weather the market’s inevitable ups and downs.
Fortunately, when you remain patient, holding investments for the long-term generally leads to annualized returns “normalizing” over longer periods of time.
Investors with short-term investment timelines or those making withdrawals from their portfolio to supplement cash flow may need to dial back the risk on a subset of assets even if the economy is strong and you’re comfortable with the volatility of the market.
Why?
You have less time for your portfolio to recover and selling investments during downturns has lasting impacts on the long-term expected growth of your portfolio.
Setting realistic expectations about the annualized real return of a portfolio rather than focusing on average nominal returns allows investors to confidently achieve their long-term financial goals and not let a short term trend knock them off course.
A financial advisor can work with you to develop a comprehensive financial plan that encompasses market volatility and uncertainty into your investment strategy so you can be confident that the future purchasing power of your portfolio will meet your needs.
Being deliberate and thoughtful in financial planning is especially helpful in preparing for inevitable market downturns, embracing the ups and downs of the market into your strategy.
Curious about working with an advisor like Plancorp? Our financial analysis is the first step so we can understand your investment objectives and can align your investments and financial plan to them.