WOULD YOU LIKE YOUR RETURNS COMPOUNDED OR AVERAGED?

[AUTHOR'S NOTE: This is a repost of an article from november 29th, 2005. But the lesson is ALWAYS timely.]

OH, THE VEXATIONS OF VOLATILITY.

Some readers may have heard a version of the following joke:

Bill Gates walks into a bar. He sits down next to the only other patron in the bar.
The bartender says: “Wow, you’re Bill Gates. You’re worth 40 million dollars!”
The other bar patron, a downtrodden looking fellow, tips his beer to Gates and says sardonically: “I’m worth about 40 bucks. That makes our average net worth 20 billion, 20 dollars.”

So much for averages. Averages can be misleading if there is not a meaningfully large enough sample on which to base the average. But in the finance and investment world, there is a bigger problem with averages. If an “average” return is based upon a series of values that are “vexed by volatility”, the average return is not what your account balance will contain. Highly volatile returns produce, over time, lower returns than less volatile investments.

COMPOUND INTEREST IS MORE INTERESTING.

Compound interest (or a compounded return) is when you earn interest on both the principal and interest you have already earned in the prior compounding periods. Let’s look at example:

You save money in a savings account that pays compound interest annually. You put $100 in the account and forget about it. The account pays 5% interest every year. At the end of the first year you earn $5 interest. So your account has $105.

Year Two. Your account earns 5% interest on $105 and totals $110.25.

Year Three. Your account earns 5% interest on $110.25 and totals $115.76.

And so on. There are formulas and tables for calculating compounded returns, but the concept is straightforward. A compound return is money you earn on the money you already earned.

THREE MUTUAL FUNDS ALL AVERAGING FIVE PERCENT OVER THREE YEARS. COMPOUND OR AVERAGE? VOLATILITY SHOWS ALL, TELLS ALL.

We are looking at three mutual funds that all have a 5% average return over the last three years. Two are our old friends, the Slow and Steady Value Fund and the Afterburner Tech Fund. To this mix we will add the Acme Growth and Income Fund.

Slow and Steady Value Fund. This fund returned 5% in years one, two and three. It averaged 5% and also returned a 5% compounded return. So the $10,000 we invested in the fund in the first year has grown to $11,576.25.

Acme Growth and Income Fund. This fund also had an average return of 5%. However, this fund earned –5 % in year one, 10% in year two, and 10% in year three. Our three year compounded return is $11,495, $81.25 less than the Slow and Steady Fund return. This gives us a compounded return of 4.62%.

After Burner Tech Fund. Like the others, this fund had an average return of 5%. This fund lost 15% in year one, returned 25% in year two and 5% in year three. The three-year total value is $11,156.25, $420 less than the Slow and Steady fund. This gives us a compounded return of 3.8%.

THE FIRST RULE OF INVESTING: NEVER LOSE MONEY.
THE SECOND RULE OF INVESTING: NEVER LOSE MONEY.

As you can see, those negative years are the compounded return killer. Remember, it is the compound returns that you can save or spend. Average return is a less important number. And nothing is more important to compound returns than those first years, the years that build the large pool of money that earns the relatively large compounded returns later in the life of the investment.

Standard retirement investment advice is to invest aggressively when you are young and move to more conservative strategies as you approach retirement. This is great advice if you start investing early in a Secular Bull Market.

But if your early, aggressive years are years battling a long bear market, you will lose your money before you ever have a chance to hit the big returning years. That is why an absolute return investment strategy should replace a “buy and hold” strategy in a Secular Bear Market such as we face. Later, when the Secular Bear gives it up to the Secular Bull, you should have a nice nest egg to put to work. And when the Cyclical Bull Markets squeeze themselves in during the long Secular Bear Market, you must earn what you can while you can.

ABSOLUTE RETURNS MAKE NO ENEMIES IN THE DESERT OF THE REAL!