What’s the difference between average rates of return and real rates of return?
Let’s say you begin with $100,000. You invest all of it in marketable securities. Then the market goes up 25% over a 1-year period. In that case your $100,000 becomes $125,000 if you sell your securities. That’s pretty exciting.
We know that markets goes up, and down. Historically, the market goes up over time more than it goes down. However, we don’t know when, or what direction the market will move at any given time.
For example purposes we’ll say the market only drops 20%. We began with $100,000 that became $125,000. How much do we have now? We’re actually back to $100,000.
Mathematically, with regard to percentages, losses damage values more than gains advance them. That’s why we end up with a 0% real rate of return over two years in this example.
The average rate of return is a different story. The market went up 25% and then went down 20%, for a net gain of 5%. Divide it by two years, and we’ve earned an average rate of return of 2.5%.
How can you potentially increase your real rate of return while reducing exposure to market risk? Is that even possible? Perhaps it is if you can avoid the losses.
Assume for a moment that you are limited to 50% of the positive market index movement during a year. In exchange, you’ll experience zero market index related losses during a down year.
Beginning with $100,000, this time when the market goes up by 25%, you only get to keep 50% of it, or 12.5%. Your $100,000 has now become $112,500, not $125,000.
The following year the market drops by 20%. You lose 0% in a down year. How much do you have now? You still have $112,500.
The average rate of return for the period is exactly the same as it was before. 25%-20% = 5%. Divided by two, it equals 2.5% average rate of return.
What about the real money, or real rate of return? You began with $100,000, and now you have $112,500. That’s $12,500 more than what you began with, or 12.5%. Divide 12.5% by two years, and it equals 6.25% per year. That’s real money that you can spend to buy real things in retirement.
“Investment Adviser Representative of and advisory services offered through Royal Fund Management, LLC, a SEC registered investment adviser.”