You might think you are making 18%? How about 7.5%? this actually happened to someone who e-mailed me a couple of months ago, he thought he was making 18%, when in reality he was making much less than that.
How come? Because monthly statements are confusing and because the real return is found out only when you calculate what is called a “weighted average”. For example, if you have $25,000 dollars at 4%, $6,000 at 6% and $10,000 making 18%, how much are you really making? This makes a total invested of $41,000.
The formula is: multiply each fund by its return add them all up and divide the total by the total money you have invested, an example follows.
Before we go into the formula, a little about percentages: 7% is the same as 7/100 this is the same as 0.07. The “%” symbol means “divided by 100”. Therefore when you have a number such as 0.05 if you multiply this by 100 you get 5, and when talking about a percentage you say that this is 5% to make it clear that this number in reality is 0.05 and not 5.
In this case, the weighted average formula would work like this: ($25,000 x 0.04) + ($6,000 x 0.06) + ($10,000 x 0.18) = $3,160 divided then by $41,000 = 0.077 that’s 7.7% overall real return.
I challenge you to figure out your real return (don’t forget to deduct the expenses too!), most people are not even coming close to 8%.
Mutual Funds or some type of stock driven portfolio are very popular forms of investing. Much of these funds are “diversified” into other types of stocks, therefore they are not really diversified, they are just allocated into other similar types of investments.
Stock investing is just a fraction of the investment possibilities but this type of investing is the most advertised and promoted. There are many other ways of investing that outperform the stock-driven investments consistently and routinely.
We are also fooled by the “lows” and the “highs”. For example, one year was bad and we lost 10%, the next year was good and we made 10%, therefore we conclude we are even and recouped our losses. This is not the case at all, let’s use the same earlier investment of $41,000 as an example and let’s assume that its weighted average was a loss of 10% and the next year its weighted average was a gain of 10%.
It would work like this:
Year 1 lost 10%, that’s: $41,000 x 0.1 = $4,100.
Start of Year 2 we now have $41,000 – $4,100 = $36,900
Year 2 makes 10%, this means: $36,900 x 0.1 = $3,690
Start of Year 3 is $3,690 + $36,900 = $40,590
At the beginning of year 1 we had $41,000, by the end of year 2 we now have $40,590. This is a loss of $410 or a return of -1% for two years.
In most of the funds I have looked at, the average returns are usually below average with a few years of extraordinary growth preceded or followed by years of losses. In the final analysis, when you take the highs, lows and most of the below average returns, you will come to the conclusion that you very rarely have averaged 10% for one year.
This is why a conservative 10% or 11% constant rate of return outperforms easily and handsomely most of the funds out there where you can invest. There are many other alternatives available that produce these types of returns consistently and routinely,
My uncle is 70 something years of age (I hope he is not reading this) has had well over a million dollars invested in stocks since the 1960s (he wouldn’t tell me the exact amount but confessed it was well over 1 million), in over 50 years of investing in this type of product he confessed to me that overall he didn’t make much, just beat inflation by a little. He thinks 10% is excellent and hard to achieve.
I am not bashing Mutual Funds or Stock-investing, my brother is a day-trader and after 6 years at it, he thinks this year he will manage to make shy of 20% per year. I also heard from a business colleague that one of his clients made 30% gain on the stock market last year.
Some people will be able to achieve these results; I have never seen these results in any of my clients’ financials.
As a final word, what about risk? Stock (or Mutual Fund) trading IS risky. You have numerous disclaimers that you have to sign and everywhere you see the sentence “past performance is not a guarantee of future results”. Therefore it is not a matter of whether it is risky or not, it’s just a matter of how much risk are you currently being exposed to in order to realize your 7%, versus the amount of risk it would take you to consistently have a return of 10%.
My intention is that you have another look at your investment portfolio and really figure out your real rate of return casting aside all the media hype, propaganda, impressive and intelligent sounding big words and nice brochures.
There is a book written in 1934 by Benjamin Graham & David Dodd. This book forms the basis of what is called “Value Investing”. Benjamin Graham was a university professor who lost most of his money in the 1929s crash; he then recovered and became quite wealthy. One of his most notable students was Warren Buffet and the book is entitled “Security Analysis” available at amazon.com. There are many editions, get the 1934 one.