When an Average Return is Extraordinary

As parents, many of us use stories to teach our children important life lessons.  As a child, one of my favorite stories was from Aesop’s Fables and was called The Tortoise and the Hare.  The tale, as many are familiar with, involves a race between an over-confident rabbit, who gets off to a quick start, and the slow, but steady tortoise.  As a child, I thought “there’s no way the rabbit could lose a race to a turtle!” However, what I had not anticipated was that the rabbit would take an afternoon nap, and the persistent turtle would be the first to cross the finish line.  The common takeaway from the story is the idiom, “slow and steady wins the race.”

A Tale of Two Returns

The lesson of The Tortoise and the Hare has stuck with me in helping clients develop investment portfolios.  We, as a society, have always been enamored with The Hare; the baseball player who hits 50 home runs, the basketball player who makes a spectacular dunk, or the Investment Manager whose portfolio returned 30% last year.

However, when it comes to investment portfolios, just as in the fable, The Tortoise may actually be the better bet in the long run.

investment portfolios

Take two hypothetical investment managers (as shown in Figure 1).  Both managers will generate a 5% investment return over the ten year period.  Manager A, “The Tortoise,” will do so by providing relatively consistent returns on a yearly basis.  Manager B, “The Hare,” will have years in which it performs spectacularly (+30%) but will also have years in which it performs poorly (-15%).  At the end of the ten-year period, investing with The Tortoise would leave a larger balance in your account than investing with The Hare.

“How can that be?” you ask.  They both average the same return – so they should both have the same amount value at the end of the 10-year period.

The following chart (Figure 2) is a slightly deeper dive into the numbers.  The simple average (or “arithmetic” average) is computed by adding all of the returns together and dividing by the number of years.

For simplicity, we can say this is the “average” we learned in grade school.  However, the compound average (or the “geometric” average) is what matters when you’re looking at the performance of your investment accounts.  As the great mathematician Albert Einstein said, “compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t pays it.”

What Einstein meant is that the ability for the money you’ve earned on your money to earn even more money is a very powerful tool.  The compound average return takes into account that after year 1 (from Figure 1), you’d have an extra $60,000 from investing with The Tortoise and an extra $150,000 from investing with The Hare.  After year 1, your return for year 2 (4% Tortoise, 6% Hare) would be on the end-of-year 1 balances of $1,060,000 and $1,150,000, respectively.  What winds up happening is each yearly return compounds on top of the prior ones.  If you like formulas, the formula for the geometric average is below.  If not, avert your eyes briefly.

What we can see here is that at the end of the 10-year period, “The Tortoise” Manager has a compound return of 5.0% which is slightly higher than the return of “The Hare” Manager’s return of 4.1%.  The question becomes, well, why are they different?  For those who like questions answered simply and immediately, the answer is volatility.

Volatility in financial markets is one way we view risk.  So when you hear the word volatility, assume that we are generally speaking about the mathematical fluctuations that cause your portfolios performance to be different from the average.  For those of you who took Statistics 101 in college, or maybe a few science courses, you may also be familiar with the term standard deviation.  In finance, we measure risk/volatility by one standard deviation[1]. When volatility is low, we have an easier time predicting what future returns will be, which makes an investment less risky.  When volatility is high, we are less sure of what to expect and that causes uneasiness.  So back to our example, The Tortoise, slow, steady, and predictable has a much lower volatility than the erratic Hare.

[1] One standard deviation covers the middle 68% of a normal bell curve, centered on the average.  So, in our example, The Tortoise has an average return of 5.0% with a standard deviation of 1.1%.  That would mean that 68% of the time, we expect returns to be between 3.9% and 6.1%.

Conclusion

By minimizing volatility, investors keep the most amount of money in their pockets at the end of the day.  In volatile portfolios with substantial down years, like The Hare, it can take significantly more work to overcome the negative years, and at the end of the day, you may wind up with less money in your portfolio!  A simple example is a portfolio that decreases by 50% in year 1.  This portfolio would have to grow by 100% in year 2, just to break even[1].  It is important to be conscious of volatility when crafting an investment portfolio and striving to minimize risk through the use of diversification and asset allocation.  It isn’t always the speed of The Hare or the excitement of an outstanding one year return.  Sometimes, the average return over a long horizon can have extraordinary benefits.

[1] A $100 portfolio returning -50% in year 1 would result in a balance of $50 in the account.  To get back to the original investment of $100, you would need to earn an additional $50 or 100% of your $50 investment.  The portfolio has to work significantly harder to recover large losses.

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2019-07-15T15:48:43+00:00

About the Author:

Michael Fischer is a Director, Wealth Advisor at Round Table Wealth Management. Read Michael's Biography >