Financial Freedom Friday – The Truth About Rate of Return

Hey everyone! Welcome back to Financial
Freedom Friday where we discuss tips and strategies to help you achieve financial
freedom. My name is Nate Scott, it’s great to be back again. And today we’re going
to talk about something in the rate of return world that maybe you’ve heard,
maybe you haven’t heard, but I want to tell you that it’s
actually possible, and we’re going to discuss it today, to have an average rate of
return of 25% but yet actually earn absolutely nothing in the investment.
Have an average return of 25% and earn absolutely nothing. I’m here to tell you
that average returns are not the same as what an actual return is. And some of you
may have heard this before but, you know, it’s very cloudy because most of the
investment advisors you go talk to you will say, well we’ve averaged, you know,
10% over the last ten years or something like that. You say, wow that’s pretty good,
you know, in this economy or various things, and so you start to think it’s
good, but there’s a difference between an average return and an actual return. I
want to tell you a little bit about that briefly today. And so I went in and I took
just to have kind of something to base this off of, I took the last 15-16
years returns in the Dow Jones Industrial Average, the stock
index. And I went back from 2001 to 2016. In my mind I was thinking 15 years, it’s
actually 16 years, but that was my goal last 15 years, Well I
miscalculated because it counts 2001. Anyway, so I took the last 16
years essentially in the Dow Jones and I said let’s just pretend I had $100,000. I
wanted to know what the what the return would be on my investment, what it would end up being. And so you go in, and maybe you know how to do an average, all you do is
add together all the numbers and divide by how many years it was. So if I add the
return for 16 years divided by 16 that gives me an average. And the average
return for the Dow Jones was 4.9, yes, 4.94% was
the average return over that 16 year period. And so if I had $100,000 and I went into
a calculator and I just earned 4.94%
every year, just plugged in the average return every year, and I would end up
with about $216,000 at the end of that time
frame. From 2001 to to 2016 I’d make about $116,000 bucks. $216,000 would be the end result. So that’s pretty good. But that’s just if I average
it out. You know that stock markets don’t just do 4.94%
every single year, they went up, they went down, they earn different returns each
and every year. I was like, I wonder if I just actually typed in each and
every year into a calculator, the actual return that it earned that year, if I
end up with the same number. So I type in all the actual returns that
occurred instead of just averaging it and I don’t end up with $216,000, I end up a lot less. In fact, it was one $186,000 instead of $216,000. Or the actual return was under 4%, but it averaged right under 5%. So the average return and the
actual return were way different. In this case at the end of that timeframe of only fifteen years there was a 15% difference from
what you would have thought you would have had if you actually believed the
average. It’s just actually an illusion. An average return is always different
than an actual return when there are down years. If every year you actually
went up, you’re guaranteed to go up, the average return would be correct but
anytime you lose money it throws everything out of whack. And so to
illustrate that I wanted to go into instead of time out of 16 years just an
over exaggerated issue and then I’ll show you exactly what I mean. So let’s say we
have that same $100,000 and we earn a crazy return, we earn a 100% return in a year. Our $100,000 would now be worth $200,000.
But the next year we’ll say you didn’t do nearly as
well, in fact, you did very poorly and you had a -50% return.
And so you lost 50%. Well now your $200,000, 50% that’s only $100 so you’re
back to where you started. And the next year comes along you can earn 100%
and be up to $200,000 and then you’re back down if we lose another 50% the
next year. You’re back down to $100,000 So we went up 100%, we
went down 50%, up, down 50, you’re really in actuality right back where you
started with a $100,000. But if you calculated the average return,
you would have averaged a 25% rate of return and have made absolutely no money. In fact, a money manager or advisor could say in our fund the last four years we
averaged a 25% return and they’d be telling the truth. The
problem is it means absolutely nothing. It’s pointless, it’s an illusion, it’s not
actually there. Because no one cares about an average return. What you
actually made is the key and not only that, to top it all off, the market goes
up and down so the average returns go way out of whack, but on top of that
you’re probably getting charged fees and things in these types of accounts. And
those come off the top so it’s actually possible to average a positive return
and have lost money. With the way the market works and the way the fees work
inside those programs. So to be honest with you, don’t get your mind totally
stuck on the rate of return on averages that people tell. They’re just a way to
make them feel good or sound good. What you want to know is actually what’s
going on in that environment. There’s a lot of, you know, deception going on and
anytime something has the potential to go down, all the averages go completely
out the window and they really end up meaning absolutely nothing. So stay with that in your mind when you’re thinking, I don’t care what the average
return is, I want to know what the actual return is, of whatever it is I’m about to
invest in and then what it has performed with.
And remember guys, if you don’t build your financial freedom
nobody will. So let’s get to work. We’ll see you next Friday.

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