I spent some time with a very bright money manager yesterday and he shared something that I had never noticed or more importantly understood.
For simplification purposes, I will show you 4 years of stock market returns. We will start with $100,000 in our account and then I will specify a certain stock market return for that year and then the next years balance will be a result of that previous years return. Let me show you:
Year 1
Starting Balance $100,000
Stock Market Return -50%
Year 2
Starting Balance $50,000
Stock Market Return +100%
Year 3
Starting Balance $100,000
Stock Market Return -50%
Year 4
Starting Balance $50,000
Stock Market Return +100%
Year 5
Starting Balance $100,000
In this example, we had 2 years that had a 100% return and 2 years that had a -50% return. If we were to calculate the average rate of return for those four years you would get an average 25% rate of return. In reality, you finished with the same amount you started with, $100,000, no where near a 25% rate of return.
The numbers that are thrown around in your mutual fund and 401k prospectus are designed to help you, but do not tell the whole story. More time must be spent really understanding your numbers because your ability to retire depends on it.
Take your investment accounts statements out and figure out how much you started with, how much you added, and how much you have now. Do the math, you’ll be shocked at the results. (If you don’t know how to figure it out, go find someone who does, or spend 20 minutes on google. It will be time well spent)
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