3 Reasons Why Your Rate of Return Doesn't MatterSubmitted by David White & Associates on April 29th, 2020
Is it possible for someone to end up with more money by receiving a smaller rate of return compared to someone earning a higher rate of return? We will get to this in a moment. Let’s first discuss the rate of return and why it is often the only metric people care about.
Short term returns tell an incomplete story, and it is unwise to make drastic changes based on a return you see from one statement.
Investopedia defines the Rate of Return (RoR) as “the net gain or loss of an investment over a specified period, expressed as a percentage of investment’s initial cost.” The Rate of Return is what we hear most often when it is related to the market, a specific stock, or a portfolio. While it is an important metric, it is often used incorrectly rending to be practically unreliable.
If you have an investment or retirement account you may have already received a statement from the first quarter of 2020 (January 1st to March 31st). After looking at your balance, you may also notice a percentage of RoR on your statement. What does that number, the RoR, mean to us? Most often we use it as a comparison tool. Even the comparison takes place in our thoughts, we inevitably compare it to something to validate it. For example, if the news says that the market was down twenty-five percent for the first quarter, and your portfolio shows an RoR of -29% you may be upset, and rightfully so as this means you lost more than the market did during the same time. On the other hand, in the same hypothetical scenario, if your portfolio showed an RoR of -15%, you may feel happier about your situation since your account performed better than the market. At times we may even compare our rate of return with what we believe to be the norm.
We hold so much weight to the RoR, and it is also the metric we regularly share in social settings. Of course, sharing our account balances can be a little too personal. Can you imagine sharing how much money you have invested with your friends or family? Instead, we are more open to disclose our percentage return because it does not reveal how much or little money we have. We talk about it because virtually everyone talks about it. The news, your financial advisor, your investment statements, and your peers – heck, even I talk about it! The RoR is important, but not that important.
The 3 reasons why your RoR does not matter is because:
One: The RoR is a terrible metric to use for the comparison of your portfolio.
Allow me to explain using my lovely wife and I in a hypothetical example:
My wife, Dulce, and I open an account on January 1, 2020, with $100,000 each. We choose our investments and then compare our returns for the year 2020. We share our RoR’s and for the year 2020, my return was -50% while Dulce’s return was -5% (as illustrated below). Another year goes by and we get together after the year 2021 is over to see how our accounts performed. Dulce’s account earned +5% and my account earned +50% in the second year. What is our average RoR after the second year?
We both earned an average RoR of 0%, yet we both ended with significantly different balances. How is that possible? If all we used to compare was was our RoR, it would be an incomplete story, and our emotional reactions would be based on the wrong information. The fact that Dulce’s account has $24,750 more than my account should be enough for her to feel happy. Of course, any financial analyst will point out that the Time-Weighted Rate of return – a more reliable calculation – for the two portfolios is -13.6% (for mine) and -0.13% (for Dulce). The point still stands.
Using the RoR to compare our performance with someone or something else is not the most effective use of this metric. It is not reliable in that way. The reason why my hypothetical account had less money was that my account was more volatile. Even though it completely outperformed Dulce’s account in the second year, it was still not enough to make up for the big loss I had in the first year. There are other metrics that are used in investment analysis called standard deviation and beta that prove to be much more reliable data to determine performance.
What I do to determine if a portfolio is doing well or not doing well is to ask questions and look at an array of data. Was my portfolio diversified in such a way that matched my risk tolerance? Was the higher exposure of risk in my portfolio worth the return? Why was I invested in this way to begin with, what was the plan? It is hard to tell by just relying on the RoR. To find out if it was worth it, I need to have more information.
Two: A Higher RoR Does Not Necessarily Mean you End Up with More Money
In the previous example illustrated above, we saw that if a portfolio drops 50% in value, it needs to increase, not 50%, but 100% to get back to its original basis! That is tough to do in one year, in two years, or even in three years! If you spend your time chasing after returns, you may end up exposing yourself to more risk than is necessary. However, high rewards may very well be worth the high risk. Where we run into trouble is when we make ongoing investment decisions based solely on the percentage return we see on our investment statements. Short term returns tell an incomplete story, and it is unwise to make drastic changes based on a return you see from one statement.
Imagine you saw your annual investment statement and see that your RoR for the previous year was 5%. How would you feel if you found out that someone else – a friend, a family relative, or a co-worker – tells you that their portfolio returned 50% in the same year? Would you be upset? Maybe you missed an opportunity, or worse, your advisor missed an opportunity. This is precisely what happened to Dulce in my hypothetical scenario. Without the full story, she may have felt that she could have done better. We now know that the RoR tells an incomplete story.
Investing is complicated, and it is easy to fall into many traps that dig into our emotions. Emotions play a big role in the decisions we make, and that is why it is important to set boundaries. Is your money invested in a default mode, or is it invested by design? Does it have a purpose? Is it tied to a specific and measurable goal? Rather than comparing your RoR to someone else’s, compare it with your own expectations for your specific investment plan. If the RoR falls within your parameter, then you are probably on the right track.
Three: It Does Not Reveal your True Progress Towards your Goals
Who cares if someone else has a higher RoR than you! Will your goal be jeopardized if your RoR does not match someone else’s?
A better metric to use is the progress towards your goals. Of course, to measure this progress you need to have a goal for your investment. Decide your expectations early on and determine what needs to happen for you to achieve your goal. This is called an investment plan.
I use a unique tool to help me analyze an individual’s investment portfolio and design a plan that helps people meet their goals. It also tells me if their current portfolio is designed to meet their specific expectations. If you would like to know if your portfolio is properly designed according to your own specifications, please complete the online questionnaire.
Your goal should be measurable and specific. Wanting more money is not specific enough or measurable. How much money do you need and when do you need it? One of my goals is to have enough money to pay for my son’s college education. This is a great goal, but it is not specific or measurable. An investment plan often requires research. I found that in 18 years, my wife and I will need to have approximately $315,000 to pay for four years of college. One thing I can control is my ability to save, not my ability to earn a specific return. So, my plan requires me to save a specific dollar amount each year with only a modest average rate of return. So, instead of focusing on a specific RoR, my expectations fall within a wide range. Full disclosure, I expect my son’s 529 account to earn an RoR between -25% and +36% for the next 5 to 7 years. After that, I will reassess my goal and determine if that range is still suitable. The closer my son gets to college, the less risk I will feel comfortable taking. Consequently, this means the lower RoR I expect to receive.
The changes I make to my portfolio are based on a larger plan, not just a simple RoR. Monitoring your progress over time is a better alternative than monitoring your RoR. The latter will drive anyone insane, and it can inspire us to make wrong decisions. Set a goal. Make a plan and monitor it over time.
The truth is, the rate of return does matter if used appropriately.
David White & Associates–insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA/SIPC –securities and investments | Ameritas Advisory Services (AAS) – investment advisory services. AIC and AAS are not affiliated with David White & Associates.
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