Average Vs. Actual

How many times have you heard a financial planner say “on average the market returns 8% annually.”  What does that really mean and did your money grow by 8% over that same period of time?  Well if we take let’s say the S&P for the last 30 years.  Looking at all of the ups and downs during that time frame if you were to add up all of the positive growth years and the negative growth years looking only at the percentage of change and divide it by 30 the average return would come out at about 8%.  The real question then is did you really get 8% return on your money or was the actual return more or less than what they are showing?  The other challenge for the growth of your money is fees inside the account sales fee, management fee and so on.  Sometimes people will tell me that they have no load mutual funds so there are no fees in their account.  Now I’m not trying to be rude when I ask these next questions but hoping we can see more of the true reality of what’s happening.  Question 1: Are the people managing your account and all the other accounts for free?  2. Where did they get the money to feed their family?  3. How do they keep the lights on at their business?  The fact of the matter is no one is working for free.  No load mutual fund, means they’ve learned how to hide the charges.

To keep this post from turning into a novel I’m only going to go out for three years but hopefully you begin to see that average and actual are really two very different numbers.

We will assume a client wants to invest $10,000 and the client for those three years will get an average 8% rate of return during those three years.

Contribution

Year 1

Year 2

Year 3

Average Rate of Return over 3 year

Rate of Return

9%

6%

9%

8%

Contribution

$10,000

Beginning Balance

$10,000

$10,900

$11,554

Gain

$900

$654

$1,040

Ending Balance

$10,900

$11,554

$12,594

Actual Rate of Return Over 3 Years 8%

 

In a simple world that’s how the numbers would work.  Unfortunately we don’t live in a simple world and we also live in a world of fees, sales fees and management fees etc.  Something we are not ever told is that those fees have an impact on our actual rate of return.  I know that the fee numbers I am going to use will not represent everyone’s fee structure but on average this is what people commonly see.  Sales load (fee) of 5% and a mutual fund fee or management fee of 2%.  Fortunately those are small numbers so there shouldn’t be too much impact on your actual return.  Here is what the new numbers based on the assumptions above will look like.

 

Year 1

Year 2

Year 3

Rate of Return

9%

6%

9%

Average Rate of Return over 3 Years       8%

Contribution

$10,000

Sales Load

5%

Sales Load

($500)

Beginning Balance

$9,500

$10,148

$10,542

 

Gain

$855

$609

$949

Subtotal

$10,355

$10,757

$11,491

Mutual Fund Fee

2%

Fee

($207)

($215)

($230)

Ending Balance

$10,148

$10,542

$11,261

Actual Rate of return

4%

 

Are you beginning to feel like your financial plan may not have been based on accurate assumption?  Hopefully at the least you, are now wanting to dig into your retirement plan to see if it’s really going to get you where you want to be.  The impact of those two small fees has a devastating effect on your actual rate of return.  Keep in mind we have only been looking at three up years.  What happens when up and down years are incorporated into the equation much like the real market?

Lets look at what happens with both up and down years before we add in the fees.

Year 1

Year 2

Year 3

Rate of Return

20%

18%

-14%

Average Rate of Return over 3 Years      8%

Contribution

$10,000

Beginning Balance

$10,000

$12,000

$14,160

Gain

$2000

$2,160

($1,982)

Ending Balance

$12,000

$14,160

$12,178

Actual Rate of Return 6.8%

 

6.8% is still not a bad number.  Long term you could build a very nice size nest egg.  However as we add in the fees the only request I have is please don’t shoot the messenger.

 

Year 1

Year 2

Year 3

Rate of Return

20%

18%

-14%

Average Rate of Return Over 3 Years     8%

Contribution

$10,000

Sales Load

5%

Sales load 5%

($500)

Starting Balance

$9,500

$11,172

$12,919

Gain or Loss

$1,900

$2,011

$(1809)

Subtotal

$11,400

$13,183

$11,110

Fund Fee

Fee

($228)

$(264)

$(222)

Ending Balance

$11,172

$12,919

$10,888

Actual Rate of Return over the 3 Years     2.9%

 

The reasoning behind this post is all too often I have people ask “if the market is really returning 8% on average why am I not seeing that in my balances?”  Hopefully this sheds a little light on what’s happening in your account and the true difference between average and actual.

If you have any questions or need help following the numbers please let us know we would be happy to spend whatever time is needed in help you see what’s really going on.