Sarbal and Peter show why average returns mislead investors. A portfolio earning 25% average yearly over four years with $50,000 annual contributions ends up flat, not ahead, because the math of gains and losses doesn't work the way most people think.
Average doesn't matter. What matters is how much did you put in, how much did you get out? That's it.
Average rates of return don't matter. What is the rate of return is probably one of the most common things we ask before investing. Have you considered that it may not be what you really want to know? The advertised rate is typically an average rate of return. And in this video we're going to really make you rethink what why it doesn't matter whenever you invest. And so we're going to start with an example and dive into it and talk about the average rate of return and why it doesn't matter. The key word being average. Sarbal, let's begin.
Let's dive in, Peter. And then if you stick till the end, we'll talk about the perfect investment also. But let's dive into this example. So, Peter, one of the most common questions around the water cooler in the office between colleagues could be discussion on average rate of return. So, Peter, if I say to you, you have an opportunity to invest into some sort of investment that's going to guarantee you 25% average rate of return over the next four years, will that excite you to put your money in?
Yeah, I think so.
Yeah. Because mind thinks about the rates and that's all we think about, right? So let's just say there's an investment opportunity for you. It's going to earn you 25% average guaranteed over the next four years. And you're going to be putting $50,000 per year into the investment. Does it sound good?
That sounds awesome.
Let's dive into it. So the objective is to buy an investment, and the capital that we're going to put in the investment is $50,000. So, Peter, you're going to be putting $50,000 into the investment over a period of four years. Timeline is four years. And the investment is going to guarantee you 25% average rate of return.
Over 40 period. Now, Peter, can you see what I'm typing? Is that clear?
Yeah, makes sense.
All right, awesome. So let's go so 4 years, 50k per year into 25% average rate of return. So let's start with year one. So let's assume that the market did really well in year one.
And you went from, so you put in the 50k into the investment, and then in year one, you go from 50k to 100k because the market did really well. So from 50k to 100k, Peter, what's that increase in value?
That's 100% increase.
100% increase in value. Now year two comes along and let's say the market didn't do really well in year two. And so this is year two in the market.
Now your account value is down to $50,000, which is what your original amount was. Right.
So what's the reduction in the account value?
It's minus 50%.
It's minus 50%.
Now year three comes along and let's assume the market did really well and you're back to $100,000.
What's the increase from year two to year three in terms of account value?
100%.
100%. And now year four comes along and market doesn't do as good. And now you're back to $50,000. What's the reduction in value from year three to year four?
It's negative 50%.
Doesn't this what happens in the stock market? And again, I'm just demonstrating this as an example, as a teaching point about average rate of return. Now, Peter, how much did you put into this investment to begin with?
I put in $50,000.
And you had your money for four years, right?
Right.
What's the account value at the end of the four years?
It looks to be the same. $50,000.
It looks to be the same. And I'm your investment advisor in this case. And you call me up and you said, cerblo, you guaranteed me 25% average rate of return in four years. I only have what I put in back in four years. Where is the average rate of return? I'm going to hold you accountable to it because you promised me 25% average rate of return. And my response to you, Peter, is, well, Peter, let's do the math. You actually made 25% average rate of return. And you're baffled when I say that because you're like, you must be doing math differently. Cereblo, I thought you were an engineer. I put in 50k at the end of the four years, I have 50k. Where is the 25% average rate of return? And I said to you, Peter, okay, year one, you had a 100% increase in your value, right?
Because from 50K you went to 100K. In year two, you had a 50% reduction. So minus 50%. Year three, you had a 100% increase.
And year four, you had a 50% reduction.
With me so far, Peter?
Yes.
So 100 minus 50. So 100 minus 50 plus 100 minus 50 is how much?
100.
100%. And how long was the money invested for?
Four years.
Four years. There you go. So you did average 25% over the last four years, but you didn't make any money. In fact, you lost money. Because if you consider the time value of money and the fees and all that, over the last four years, you didn't make any money. You lost money. You started with 50k, you're back in 50k. So again, this is just a teaching point, guys. This is the average rate of renowned example. You may not make money, but you'll still earn the 25% average rate of return. So when you're making decisions on investing and things like that, be careful about averages. Averages don't matter. Try to understand the emotions behind the investment, the characteristics behind the investment that'll help you analyze what a true rate of return. What is the outcome from the investment going to be? Average doesn't matter. What matters is how much did you put in, how much did you get out? That's it.
And to know more about the perfect investment out there, well, make sure that you check out our video, which is going to pop up right here, which is going to describe to you the characteristics behind the perfect investment that is out there. It's been in existence in Canada for over 150 years.
