When you’re planning for retirement, it’s easy to get lost in a sea of numbers and end up with more confusion than direction. However, it’s vital to understand some metrics as you decide how to invest your nest egg. One of the most important figures is rate of return, also referred to as ROR.
There are three important measures of this rate of return, and it’s good to have a basic understanding of each, since they account differently for things such as expected profits, risk, volatility and other factors. They are average ROR, CAGR, which stands for compound annual growth rate, and ROR Standard Deviation.
Average ROR and Your Retirement Planning
First, know that return means profit earned on an investment, but it can also be a negative number if the fund or stock in question did poorly. The percentage is, at its core, a simple formula. To calculate, add the rate of return for each period together and then divide by the number of periods. If you’re looking for an average yearly ROR, for example, you would compare the account’s value at the beginning of the first year to value at the end that year for the first number and so on to calculate percentage increase figures. Then, add those numbers and divide.
The calculations aren’t difficult at first glance, this metric can be misleading. It’s easiest to explain by example. Imagine that in year one, the fund starts at a value of $100,000. At the end of the year, it’s jumped to $200,000, meaning an increase of 100 percent. The next year, it drops back to $100,000, meaning a decrease of 50 percent. The third year, it goes back up to $200,000—another 100 percent increase. By year four, it’s back to your original amount, $100,000, to represent a decrease of 50 percent. When you calculate 100 -50 + 100 – 50 and divide it all by 4, you get 25 percent. But is it right to say there was a 25 percent rate of return when you didn’t earn anything (not to mention two years of high taxes)?
Clearly, it’s easy to misinterpret the average ROR. If your money had really grown 25 percent per year, compounded annually you would have closer to $270,000.
Unfortunately, some unscrupulous financial advisors and mutual funds sellers take advantage of misleading average RORs to tout massive returns on accounts that aren’t really doing very well. For these figures, make sure you understand the different rates of return for each time period and that you also look at things like long-term risk and volatility.
Understanding the CAGR
Another way to understand ROR for your retirement investments is the CAGR. This compounded rate is used to smooth out the averages to give a more realistic picture of steady growth. This number is usually 1-3 percentage points lower than the average ROR on a given stock or fund. In technical terms, the calculation is a geometric progression ratio.
For example, the average ROR on the S&P Index between 1995 and 2014 was 9.12 percent, even though the years of 2001, 2001, 2001 and 2008 saw significant losses. But if you calculate the CAGR, the figure is a more realistic 7.26 percent.
All metrics have their flaws, and this multi-year average is where the trouble with the CAGR becomes apparent—it doesn’t represent risk. It might seem that 7.26 percent is good, and it probably is over time. But you have to remember that in 2008, when the market lost nearly 40 percent of its value, millions of people lost huge portions of their hard-earned retirement savings. This shows how you may need to look beyond the CAGR before you make any long-term wealth management decisions, especially if you’re considering a stock or mutual fund with a history of big ups and downs.
Completing the Picture with ROR Standard Deviation
To fully understand risk, you need to account for the amount of difference, or dispersion, of your data set. Think of this as the amount of difference between the annual rates of return. This is a statistical measure based on the square root of the variance. It is also known as historical volatility. A higher number means more risk, so make sure you look at this metric, especially if you’re comparing two assets within the same asset class.
Contact Safeguard Investment to Learn More
Whether you’re a math whiz or not, understanding these ROR figures is only part of evaluating your investment choices. Our financial professionals can help you craft a strategy based on a wider range of metrics and additional information, and we would be happy to meet with you for a free consultation. Contact us by filling out the form at the bottom of this page.