One reason the stock market is so well-regarded in typical finance is because people believe they can get a 12% “average” ROR. When combined with dollar-cost-averaging, people think they can “beat” the downsides and only experience the upsides of the market. And while most people know logically that average doesn’t mean “12 percent every year,” they typically expect something resembling 12% when they look back at their investments over time. Unfortunately, that’s just not how averages work.
The best way to explain why average rates of return mean nothing is to give an example. For this, we’ll use the Cash Flow calculator, although you can also do the math in your head.
Pretend that you invested $100,000 into a mutual fund that had promised an average rate of return of 25% if you left the money alone for 2 years. In the first year, it earned 100%.
After the first year, the investment would look like this:
As you can see, the $100,000 turned into $200,000 over the course of one year.
Then, unfortunately, in the second year you experience a rough patch and your account actually experiences a 50% loss. Now, your investment looks like this:
That’s right, you’re right back where you started. So while your average return is 25 percent—and yes, that’s mathematically correct—your actual yield is 0%.
Still in disbelief? An average is calculated by adding up all relevant sums and then dividing by the number of sums. In this case, our two rates are 100% and -50%. Divide that by two, and you get 25%.
How happy would you be with the broker who promised you an average of 25% only to receive an actual result of zero? You are probably not very happy, and yet the broker delivered on their promise. They’re off the hook.
Are you starting to see why averages don’t actually mean all that much when it comes to your finances? If you apply this logic to your investments supposedly averaging 12%, it’s easy to see how that could mean almost anything. It could work out, or it could mean absolutely nothing. You could even end up with less. It’s all smoke and mirrors.
If averages aren’t accurate, then surely there’s some equation out there that can help, right? That’s where CAGR comes in, or Compound Annual Growth Rate. CAGR is a way of calculating how an investment would have had to perform in order to reach its current result. In other words, it’s a retroactive calculation (not a projection or prediction) to explain how you got your results.
Let’s say you invested $100,000 and ten years later you have $235,000. The CAGR would calculate what consistent rate you would have to earn over a specific time frame in order to get there. It’s more accurate than an average because it’s based on your real results.
Here’s what that calculation looks like:
Source: Investopedia
But, if you’re not a mathematician, Truth Concepts makes it easy for you. You can actually use our Rate Calculator to figure out the necessary ROR to get from point A to point B over a specific period of time.
So what would it take to get from $100,000 to $235,000 over 10 years with no additional contributions? 8.92%.
In fact, you can even add consistent contributions or withdrawals over this time frame. Say you add $5,000 annually over this 10 year span. Now, your CAGR is only 5.49%.
While the CAGR is not an average of what occurred over those 10 years, it is a more accurate depiction of the results. You experienced 5.49% growth.
If you want to get more complex, try using Cash Value to add more variables. With Cash Value, you can add varying payment streams, withdrawals, and variable interest rates. You can pull real stock market data straight from our Market History tool and paste it into the Rate Column in Cash Flow to do an accurate simulation of the stock market. Then, when you’re done playing, you can use the Rate Calculator to calculate the CAGR.
Here’s an example of a more complex stock market simulation in Cash Flow:
The above cash flow shows a 35-year-old who dumps $100,000 into the stock market and then continues to contribute $5,000 a year. Then, in the 8th year, he gets a raise and decides to contribute $5,000 more a year.
The earnings rate is pulled directly from the last few decades of the S&P without dividends.
The average ROR is shown in the bottom row labeled Totals as 5.13%. Yet, if you add the beginning and ending sums into a Rate Calculator, you’ll see that the CAGR. Note: We have to break this into two calculations to be accurate. In the first 7 years, he’s contributing $5,000 and after that is contributing $10,000.
In the first 7 years, the actual growth he experiences is 0.48% (shown below). Meanwhile, the average ROR for those first 7 years is 4.95%.
In the next 13 years, the client’s actual growth is 6.3%. This is quite a bit better than the first 13 years. And yet, his average for those 13 years is 7.02%.
So we’ll ask you: which number is more valuable to you?
To learn more about financial concepts like the above, and how to illustrate them, attend one of our premier Truth Training events. You’ll learn how to make complex financial topics simple with our suite of calculators. Or, sign up now for a Truth Concepts 360° membership and get access to our exclusive video training.