Weekend Reading: What’s the Difference Between Average and Actual Rate of Return?
This article appears as part of Casey Weade's Weekend Reading for Retirees series. Every Friday, Casey highlights four hand-picked articles on trending retirement topics and delivers them straight to your email inbox. Get on the list here.
Language matters, especially in the financial industry. With rate of return being such a primary factor for basing investment decisions, you should know there are actually two different types: Average rate of return and actual (or real) rate of return. Both are not created equal, so here is the difference:
READ THE ARTICLEAverage rate of return: This is calculated by adding all your annual investment returns together, then dividing that number by the time commitment. What many might not realize, however, is that this total can mask losses some years with gains.
Actual rate of return: This total involves a process of recalculating investment returns so that the number reflects both gains and losses. It’s the rate of return you should be paying most attention to.
Sequence of returns risk: In addition to focusing on the real rate of return for an investment, it’s crucial to factor in the potential for sequence of returns risk. As shown in the article example, just one loss in retirement can impact your nest egg total down the road. And, if you are not aligning that number with the proper rate of return, your forecasted total can become even more skewed.
Remember this: While it’s easy to take average return at face value, it’s more important to look at a relevant “actual rate of return”.