What is an Average Return?

Our July class will focus on expectations. It’s important to have realistic and rational expectations about the performance of portfolios. Without realistic expectations, investors may be easily convinced to abandon a solid long term plan after only a short period of low performance. Or, they may form too lofty of expectations after periods of very strong performance.

One of the ways investors can become confused is by the use of average returns; with the expectation that most years are close to average.

In the real world however, we rarely ever experience an “average” year.

Here is an example. If we look at the 1993-2013 performance of Matson Money’s Long Term Growth portfolio, gross of fees, the arithmetic average annual return was 9.93%. (Keep in mind ¼ of the portfolio is not in stocks). But looking back at these years, how many actual years had a 9% return? The answer: Just one. 1997 with a return of 9.86%. What if we include years where the return was either 8, 9, or 10%? In that case we have 1997, and 2005 (with a return of 10.27%). So, out of the 21 years, only 2 were near average. But this next statistic should surprise you. Out of those 21 years, how many years had a return of under 5% or over 11%? The answer: 17! Most of the years were not even close to average. Since that is the case, investors must be weary of looking too closely at short term performance (either low OR high), to create expectations of long run returns. “Average” returns are the result of a combination of very low and high performing years, not consistent repetition of the same returns year over year.

We hope to see you in class over the next coming months.