Personal Finance 101: How Much Money Is That Investment Really Earning Each Year?

Understanding the Annual Rate of Return and What it Means for You

pf101Quite often, when you see an advertisement trumpeting the amazing annual rate of return of an investment, you’re not seeing the full picture of how good that investment really is. The annual rate of return, while an interesting metric, doesn’t really tell you how much money you can expect to earn in an investment over a period of several years – in fact, you’ll almost always earn substantially less than you think if you expect to get that advertised rate.

How does this work? Let’s take a look at a real world example – the S&P 500. Here are the annual rates of return of the S&P 500 over eight recent years.

In 2000, the S&P 500 returned -10.14%.
In 2001, the S&P 500 returned -13.04%.
In 2002, the S&P 500 returned -23.37%.
In 2003, the S&P 500 returned 26.39%.
In 2004, the S&P 500 returned 9.00%.
In 2005, the S&P 500 returned 3.01%.
In 2006, the S&P 500 returned 12.80%.
In 2007, the S&P 500 returned 3.81%.

Annual rate of return

Almost all advertising for mutual funds uses the average annual rate of return to talk about how “good” that investment is. It’s pretty easy to calculate the average annual rate of return – just add up all the numbers and divide by the number of years.

In the above case, the average annual rate of return is 1.06% (it’s actually -3.31% if you want to include the abysmal 2008 in your numbers). Considering that this period includes two severe recessionary markets and only one bull market, that’s actually fairly reasonable.

One would expect, then, that an investment of $100 in that fund from 2000 to 2007 would earn 1.06% each year, leaving us with a total of $108.80 after the eight years, right?

Actually, that’s wrong – but it’s what the investment advertisers would like you to think.

How it actually works:

If you walk through the numbers, year by year, you’ll see that in fact you would wind up with less than $108.08 in your investment.

In 2000, the S&P 500 returned -10.14%, meaning your $100 investment became worth $89.86.
In 2001, the S&P 500 returned -13.04%, meaning your $89.86 investment became worth $78.14.
In 2002, the S&P 500 returned -23.37%, meaning your $78.14 investment became worth $59.88.
In 2003, the S&P 500 returned 26.39%, meaning your $59.88 investment became worth $75.68.
In 2004, the S&P 500 returned 9.00%, meaning your $75.68 investment became worth $82.49.
In 2005, the S&P 500 returned 3.01%, meaning your $82.49 investment became worth $84.97.
In 2006, the S&P 500 returned 12.80%, meaning your $84.97 investment became worth $93.05.
In 2007, the S&P 500 returned 3.81%, meaning your $93.05 investment became $96.60.

So, while the ad might brag about a 1.06% annual rate of return, the truth is that you actually lost a bit of money in that investment.

Why?

The average annual growth rate – which grew 1.06% over the period, remember – is only accurate if you reset the investment to $100 each and every year at the end of the year. That means that at the end of each losing year, you contribute enough extra money to bring the balance back to $100, and at the end of each winning year, you take out all of your gains.

That’s not how most people invest – we tend to buy and hold, not take out our gains every year. Thus, the “average annual rate of return” really doesn’t mean too much to us. Investment houses use it because it’s a simple and accurate number that is almost always higher than the real returns we would see if we were investing.

What can you do?

If you’re considering an investment, don’t pay any attention to the average annual rate of return. Instead, focus entirely on the compound annual growth rate – that’s the interest rate that truly reflects how much you’ll earn over a longer-term investment if you just buy and hold. Look for that number in the investment literature – and if you can’t find it, ask for it.