Rates of Return on Investments: Don’t be Fooled!

If I told you that an individual placed an initial investment of $100,000 with a money manager and after one year, they had $200,000, you would tell me that they had a 100% gain on their investment, right? What if at the end of year two, they had only the original $100,000 in the investment account? What would you tell me the rate of return was on the investment? “0” you say? Well, there are a lot of money managers that would translate that into a 25% return on the investment! Go figure! Let’s take a look at how they figure that out!

First, if you look up rates of return, you will see that many fund managers use an arithmetic return average and not a compound or geometric return calculation. So, the formula that is used is something like this:

Return (–) Original Capital (/) Original Capital (x) 100% = Rate of Return.

The formula for multiple years is simply, the rate of return for the first year + rate of return for second year + rate of return for the third year (and so on) (/) number of years.

Plug in the numbers and here it is:

200,000 – 100,000 / 100,000 x 100% = 100% or

more realistically… using numbers that make are more in line with what one could hope for…

110,000 – 100,000 / 100,000 x 100% = 10% return on investment

So, let’s do a multi-year calculation with the initial investment of $100,000. Say it grew to $200,000 at the end of year one; a 100% return. At the end of year two, the account has only $100,000; a gain of -50%. At the end of year three, value is at $200,000; a 100% gain for that year. In year four, the account shows a value of $100,000; once again a gain of -50%. You and I would say, you have no gain over the four year period. But… a money manager would say that the average rate of return was 25%! As the title of this post says, “don’t be fooled”!!!

If we use a geometric or compounded calculations, we would realize we had a “0%” gain. And if we consider that four years have passed and calculate inflation factors, we clearly are in a worse position than we were four years earlier!

If you are in a mutual fund that is not performing very well or considering investing in a fund, do not let yourself be fooled by money manager’s average rates of return!

Before you invest any more of your hard earned money, watch this 2 minute video!