You Can’t Handle The Truth!

That was the response of Jack Nicholson’s character (Colonel Jessep) to Tom Cruise’s character in the most memorable scene in the movie A Few Good Men.  In writing this post, I feel a bit like Colonel Jessep.  Most Americans simply cannot handle the truth.  That is my conclusion.  Although, trying to allow the benefit of doubt, another possibility is that they simply do not want to know the truth.  And why wouldn’t they want to know?  Because they can’t handle it.

What does this scene from a popular movie have to do with financial matters?  Pretty simple really.  One of the biggest secrets within the investment industry is that mutual funds, variable annuities and countless other products tied to the whims of the stock market, advertise their average return numbers in a very misleading way.  And do you know what really gets to me?  They are not breaking any written laws by their practices.

I know…there’s a collective gasp sweeping its way across everyone reading this blog post.  Or is there?  It seems like everywhere we turn some politician or other talking head is not giving us the truth.  So maybe many reading this post are just yawning and saying “so what?”

SO WHAT?  This slight of hand is costing you thousands of dollars.  Costing you time.  Re-routing your future.  To where? Someplace you do not even know or expect.  Not only re-routing your future – possibly making your hoped for retirement non-existent or impossible.

I have been following the investment world for a few decades.  I have done countless calculations to determine how much I am going to have in retirement or how much I need to save to have the kind of retirement I want.  But the reality is far different.  You see, by my own experience I’ve noticed that almost all investment product companies (mutual funds, ETFs, stock market indices, variable annuities, closed end funds, REITs) love to cite their “average annual rate of return” figures which always inflate what the particular investment actually returned to its investors. And it really bothers me.

2+2=4 right?  Always?  Not necessarily on Wall Street.

This problem isn’t complicated nor is it really nuanced in any particular way,(as the investment industry would have you believe) it really comes down to basic math.

Average annual return, as is always stated in investment literature, (marketing pieces, prospectuses, etc.) is simply a deliberate shell game meant to confuse your perception of the returns by stating simple arithmetic mean calculations. I feel the only meaningful number that matters is the compound annual growth rate (CAGR).  What is CAGR? It is a calculated number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns.  Some people like to say that this is the cumulative rate of return. Most simply put – MY ACTUAL RETURN.

I can hear you now…. “Dr. Henderson you are getting worked up over nothing, you are splitting hairs here.” Please hang with me through an example and you’ll understand my beef.
Example:

Let’s say that Bill invests $100,000  into his investment account at J.T. Baker and for the 1st year  his account grew by 25%.  This is great.  But the account returned a negative 25% the second year.

Stock market muppets would say your average return is 0%…and they’d be telling the truth.  How much money to you think Bill has in his account? (Answer – $100,000.00.  Really?  What is the real answer?)

However, the muppets are clouding the truth with a statement that has no relationship to what you actually experienced.

Here is what Bill actually experienced:
Year 1- 100,000 +  (25% x 100,000.00) =    125,000
Year 2 – 125,000 – (25% x 120,000) =    93,750

Bill started with 100k and now at the end of year two his account is worth $93,750 his actual compound annual growth rate (CAGR) was -6.25%.  Negative 6.25 percent growth per year for two years gives me an actual result that a lot different than if I said you had a 0% average rate of return for two year.

With a 0% average rate of return, how can Bill have less money than what he started with?

Welcome to the wonderful world of investments and the imagineers of Wall Street.

Remember how I defined CAGR?  Guess what I found on-line at investopedia.com (http://www.investopedia.com/terms/c/cagr.asp):

CAGR isn’t the actual return in reality. It’s an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns.(The emphasis is mine.)

Are you kidding me?  I think the accountants that were at Enron have found a new job writing for Investopedia.

In most professions and in every place except Wall Street this kind of definition would get you thrown in Jail or out of town.

Would you care what you “averaged” over the last two years if your stack of money is shorter than when you started? That’s NOT a zero sum game.  Who cares about an average?

Here is a question for you; Why would the investment world always quote the average return numbers?

Go ahead and take a moment to think that one through.  Have an answer yet?  The answer is: Because average annual returns always look better than actual, real returns.  The fact is most stock market investments are volatile and showing you the average return (arithmetic mean) makes them more attractive.

Over at moneychimp.com there is a fun calculator.  I wanted to see what the average rate of return on the S&P 500 was for the last 14 years.  The calculator showed me the following:

From Jan 1,2000 to Dec 31, 2013
Average rate of Return: 3.06%
CAGR: 1.17
$1.00 grew to $1.18

There is a big difference between the average rate of return and the CAGR.  If the actual return had been 3.06 percent over those 13 years $1.00 would be $1.48.  I can hear you complaining again, Dr. Henderson you are talking a difference of 30 whole pennies.  In reality what we are talking here is a difference of about 26%.

What adds insult to injury is that there has actually been periods of time (and they are not all the infrequent) when the average rate of return is a positive number when the actual rate of return is a negative number.

Here is an interesting excerpt from Warren Buffet’s book The Essays of Warren Buffett: Lessons for Corporate America.  He could easily be talking about this very issue.

Over the years, Charlie and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with pen than small sums with a gun.

Take to heart what Buffet is saying in this quote, it applies here!

What is really unfortunate about this whole situation, is that I think the majority of people who perpetuate this lie, have no idea they’re doing anything wrong!  The calculations using average rates of return are so embedded that even advisors, CFPs, investment advisers and other financial professionals spout off the numbers without questioning their validity. I am not going to go so far to accuse anyone of being deliberately dishonest.

But the question has to be asked – which is worse, being dishonest or ignorant?

If you have stuck with me this far you are asking what do I advise you to do?  I advise you to get educated – first visit my website (www.hendersonandfloyd.com) and sign in to get a series of free 5 minute videos that will raise your financial IQ considerably. Last but not least; do the math yourself and ask lots of questions.  Only then can you be confident that you’ve made a wise decision.