I see where you’re coming from, and I totally get your frustration. It’s a bit like the “truth” moment in A Few Good Men—the reality is often hidden behind layers of jargon and misleading simplifications, especially in the world of investing. The focus on average returns in the financial industry can indeed obscure the true picture, and that can be incredibly misleading for investors who don’t understand the difference between average returns and actual growth, particularly when we’re talking about the compound annual growth rate (CAGR).
Let’s break down why this is such a big deal and why it’s worth paying attention to the real numbers, not the “averaged” ones.
The “Averaging” Game and Why It’s Misleading
As you pointed out with the example of Bill’s investment account, the average return figure used by mutual funds, annuities, and other financial products can hide the true performance of an investment. In your example, Bill has a $100,000 investment, which grows by 25% in the first year but drops by 25% in the second year. According to the traditional “average annual return” method, Bill’s return for the two years would be 0%. But in reality, his actual compound return is -6.25% over the two-year period.
Here’s the math behind it:
- First year: 100,000 x 25% = 125,000
- After two years, 125,000 x (-25%) = 93,750
After two years, Bill has $93,750, a loss of $6,250. However, if you just looked at the average of the two returns (25% and -25%), you’d conclude that the investment had no gain or loss (0% average). This is a prime example of how averaging can mask the true story. The investment didn’t average to zero in real terms—it lost money. But it looked neutral on paper.
The Key: Compound Annual Growth Rate (CAGR)
This is where the CAGR comes in. The CAGR represents the true, consistent annual return that would have resulted in the same final value as the actual investment over the given time period. It’s the real rate of growth, taking into account the compounding effect that can make a big difference.
In your example:
- Initial investment: $100,000
- Final value after 2 years: $93,750
- Years: 2
So, despite the “average” return being 0%, Bill actually experienced a -6.25% compounded return, which is a substantial loss over the two years. This is the key distinction—CAGR reflects the true growth (or loss) of the investment, while average returns can obscure the reality.
Why the Investment Industry Uses Average Returns
Now, you might be wondering why the industry continues to rely on average returns. The short answer is: they are often more flattering. Average returns make it seem like an investment is doing better than it really is. This can be especially true if the market has had a few strong years followed by weak ones—averages tend to smooth out the volatility, making the results look more appealing to potential investors.
To be clear, this doesn’t mean the people citing these averages are trying to deceive you on purpose. In fact, many financial professionals and marketers might not even be aware that they’re relying on an oversimplified metric that distorts reality. It’s how the system works, and as you said, it’s so ingrained that it becomes part of the default financial “truth.”
However, as you wisely point out, it’s up to us—investors and consumers—to ask the right questions and dive deeper into the numbers.
Inflation’s Impact: The Hidden Erosion of Returns
And then there’s inflation, which compounds the problem. Let’s say your average return looks good on paper, but when you factor in inflation, the real return can be significantly lower, or even negative. The investment community doesn’t always highlight the impact of inflation, but it erodes purchasing power over time.
Tools like the ones at Moneychimp, which allow you to adjust for inflation, are incredibly useful to see a more realistic picture of how your investments are truly performing in terms of real wealth-building. If inflation is running at 3% per year, and your “average” return is only 5%, your real return is closer to 2%—not the 5% you might have thought you were earning.
The Bottom Line: Question Everything
Ultimately, your advice rings true: ask questions, and don’t take numbers at face value. Calculating CAGR yourself and factoring in inflation can give you a much clearer picture of how your investments are actually performing. This is where financial literacy truly pays off—it’s about more than just trusting averages; it’s about understanding the actual math behind the numbers.
When you start comparing investments, don’t just look at their advertised “average returns”—ask for the CAGR (and account for inflation). That’s where you’ll get the real story about your money’s growth or decline.
The more informed you are, the better your chances of navigating the “Wall Street shell game” with clarity, and as you wisely put it: “the only return that matters is your actual return.”
If you keep questioning the numbers and crunching the real data, you’ll be in a far better position to make smart investment decisions.
