Thanks for joining us again. Our stocks have been selected, along with how much to invest, when and how. Congratulations, you are now an investor in one of the best investments for your finances. The stock market. If you are new to the series, I suggest you start from the beginning.
ALL IS NOT AS IT MAY APPEAR
Whether you are a buy and hold investor, or a buy and sell investor you will still be interested in reviewing your stocks. It is not as simple as it first appears.
We will often receive an annual report from our stock broker or online provider of how your stocks have done that year. 5%, 9%, 2%, -5% and so on. So, if our stocks over 10 years have returned 70% in total, that is 7% per annum right? WRONG.
I didn’t mean to scream in bold caps lock, but it is a common misunderstanding. The only way your returns were 7% would have been if your investments returned 7% every year for 10 years. Highly unlikely by the way. We know that the stock market can be extremely volatile and returns tend not to happen in a straight line. Even if the average returns over 10 years were 7% we can end up with LESS than the average. See the example below from a $10,000 investment:
If we were judging our result based on the average return of our investments over 10 years we would have ended up with $19,672. BUT, this is not would actually be in our account at the 10 years. The difference is due to the order in which returns happen. In this example, the sequence of returns was not favourable to us, and we ended up with $17,826. Almost $2,000 less than the ‘quoted’ average. The $17,826 number (real or actual number) is known as the compounded annualized growth rate, or CAGR for short. This is the number we should be interested in. After all this is the number that delivers the money in the bank. The average is just that, an average.
$2,000 difference over 10 years may not seem like a big deal, but what if we extend the timeframe out to 30 years and change the amount invested to $100,000?
Now we are looking at a difference of almost $80,000. Same 7% average, but sequence of returns makes all the difference. After 22 years, the actual returns are looking pretty good, but it is the negative returns towards the end that really impact our returns. Low returns when starting have a much smaller impact than they do after a longer period. Think about this – A negative 1% return on $1000 is only $10. A negative 1% return on $300,000 is $3,000. In an ideal world, we would experience the worst years when starting out and the best years towards the end of our investing time.
How do we explain this phenomenon? Say our $10,000 grows 100% in the first year to $20,000. The following year our investment falls 50%, taking us back to your original amount of $10,000. Over 2 years then, our annualised gain, or CAGR is zero. However, an adviser who is keen to put a positive spin on the numbers may tell us that our return is actually 25%. This is the average return and as you can see in the tables above, is very misleading. In real life, we only realise the CAGR, not the average annual return many brokers and fund managers claim. So, please don’t be fooled by the numbers. When someone gives you the average return from the stock market, it may not be the real return.
Negative returns are what make the biggest impact. Say we have $50,000 to invest and experience 20% returns in our first year. At the end of the year we will have $60,000. In the second year we lose 20%, so back to $50,000 right? Wrong again. Even though the average return is 0%, we have actually lost money. 20% loss on $60,000 is $12,000 taking our year 2 balance to $48,000. $2,000 less than we started with. A CAGR of minus 2%.
What if we reverse the sequence so we lose 20% in the first year and gain 20% in the second year? We still end up with $48,000, CAGR minus 2%.
Whenever we lose money, it takes a greater return just to break even. If we lose 20%, we must earn 25% to get back to where we began. The more we lose, the worse it gets. Lose 50% and we need 100% to get back to even. On the flipside, gain 100% and we only need to lose 50% to get back to even. This is why it is so important when investing to lower our downside risk and protect our gains as best we can to minimise our exposure to losing money. It’s much better to have compounding working for us and our gains, than against us with losses.
HOW DO WE SMOOTH THE EFFECTS OF CAGR?
The CAGR can be both higher or lower than the average depending on the sequence of the returns. It can sometimes be a significant difference too, especially if the negative returns are predominantly experienced in our later investing years. Here are a few actions to help minimise the effects of negative compounding:
- Well diversified portfolio
- Dollar cost averaging
- Rebalancing your portfolio
- Have a professional manage a portion of your portfolio in mutual funds
- Minimise the fees you pay to invest
- Be prepared to sell, although beware of trying to time the market
- Reduce your holdings in stocks as you get closer to your retirement.
All these tips have been explained in further detail earlier in the investing series. If you need a refresher the series begun on the 1st of June here.
Once we have made the decision to invest it is still important to review our results. It is not always going to be smooth sailing and there will be times where our portfolio allocation changes because of one asset class outperforming another. Rebalancing will be needed to reduce our risk exposure. When looking at our results it is important to look at our CAGR average though, and not the mathematical average. Otherwise we will not be comparing apples with apples.
Just remember, if an investment such as a bank term deposit or bond coupon returns a flat percentage, then that is our return. There is no CAGR. The CAGR is only relevant where our returns are up and down every year, such as stocks. Then we can compare correctly across different asset classes to see which one is performing the best. CAGR of stocks vs average of bonds is the correct way to compare. Average of stocks vs average of bonds will not be accurate.
Sequence of returns becomes very important as we approach retirement. Sure, a $50,000 difference in calculations when we are younger can be recovered. Later in life though, it can be the difference between retiring with enough money or not.
In the next article of the series we will discuss the impact that inflation and fees can have on our returns. Easy to forget, but very important as part of reviewing the success of our investments.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here
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