Don't be fooled by average returns - it's compound returns that count!

May 1, 2018

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A few clients this week have asked me if it’s a good idea to invest a large sum in the share market at the moment (for a variety of reasons e.g. as super contributions, a gearing strategy and so on). I told these clients that I have some real concerns with it – not because I don’t have faith in the stock market – but because of the difference between actual versus compound returns.

As these charts demonstrate, the US and Australian stock markets are close to their peaks since the GFC hit nearly a decade ago. Whilst I’m cautious of not falling into the trap of trying to predict how the market will perform in the short term, I know that markets are risky when they are at their peak.

I also know that large losses and/or volatility can take a while to recover from (mathematically). That is why Benjamin Graham taught Warren Buffett that there are only two rules to investing:

Rule # 1: never lose money; and
Rule # 2: refer to rule number one.

Average versus compound returns

Consider this example: you invest $100,000 in a share market managed fund that delivers the following returns over 5 years:

Year 1                    -22%
Year 2                    2%
Year 3                   40%
Year 4                    -10%
Year 5                   25%

The average return over the 5 years is 7.0% p.a. However, the compound annual return is only 4.6% (i.e. your initial $100,000 investment has increase to $125,307 after 5 years).

Why?

If you have $100 and lose 50%, you will have $50. If you make 50% back the following year, you will have $75, not $100. So, you need to make a 100% return just to get back to where you started. That is why Benjamin Graham taught Warren Buffett how important it is to never lose money.

What does this all mean?

There are two main learnings we can draw from this basic yet imperative concept:

Take whatever steps necessary to avoid losses. Don’t put your eggs in one basket. Instead, put your eggs in various baskets – which includes (for example) investing in multiple asset classes, diversify amongst various passive (index) share market methodologies, diversity architecturally and geographically with respect to property, invest gradually over time (which is referred to as dollar-cost averaging) and so on. The strategy should be to invest in such a way that you c

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