As a child, perhaps you can recall your parents cursing that one unkept house on the street bringing down the property value of the entire neighborhood. Our neighbor at the end of the block, we’ll call “Tucker” for purposes of this story, was one such example. Tucker might typically mow his lawn once per month, had a broken down jalopy in his driveway, was in need of a new roof, had overgrown shrubbery, several low hanging tree limbs, and undoubtedly a rodent infestation among several other problems – you get the idea. A real dump. If the other houses in the neighborhood are all worth $150,000 and Tucker’s dilapidated money pit sells for $75,000, then surely this amount will bring down the neighborhood property value as an average.
Fair or not, that’s the truth about averages. One really good or bad outlier can unfairly distort the average as a whole. (It’s why some folks prefer median as a true measure of center). Tucker is just one example of how an average can be misleading.
Consider the average annual rate of return used by many financial institutions as part of investment pitches. This often involves an arithmetic average, much like we used in the Tucker example from above. Many of us were taught how to calculate arithmetic averages like this early on in school. To calculate an average annual rate of return, add up all the yearly percentages and divide by the number of percentages.
To illustrate the flaws in this method, look at this simple example using basic monetary amounts. Suppose you invest $100. The investment loses 50% the first year and gains 100% the second year. If we calculate the average annual rate of return, (-50 +100) / 2 = 25%. So your investment should have grown 25% or $25, right?
Wrong. If your investment loses 50% in the first year, you now have $50. If you gain 100% the second year, you have made $50 (50%) and are now back at $100. Despite having an average rate of return of 25%, you have actually made $0.
This is not to say financial professionals are purposely misleading you. Just be aware of the phrase average annual rate of return. It is necessary to be dilligent when considering an investment opportunity. Remember, if your investment loses a certain percentage, you are going to have to make more than that percentage to earn back the amount lost. Ask those people that lost considerable retirement savings in 2008 how long it took for them to be made whole.
