Average Annualized Return

A question often asked by client is “what is my average annualized return”?  It is a fair question, but a simplistic answer is easy, but neither thoughtful or helpful.

Before going farther, consider looking at investment in which the average annualized return over a 3-year period is -14.8%, +14.1%, -8.5%, +13.9%.   Many if not most investors would eliminate the two options with negative returns.  The only problem, and this was a trick question, the above represents the same investment option, just for different time periods.  In each case, the above represents a different 3-year time period; 2000-2002, 2003-2005, 2006-2008, 2009-2011 for the S&P Index. 

Often the question about average annualized return comes up when stock market has declined and Portfolio market value was at a low point.  The client may be disappointed which can lead to an ill-advised and often counter-productive change in investment strategy.  This may be based on the assumption that average annualized return is predictive of the future. 

From the beginning of 1991 thru the end of 1999, the S&P Index had an outstanding average annualized return of 20.5%.  An investor reviewing this time period looking backwards would have had great incentive to invest in a mutual fund or ETF that tracks the S&P Index.  The next ten years, 2000-2009 the average annualized return was negative and twice over that ten-year time period, the Index declined by about 40%

The average annualized return for the S&P from 1991-1999 did not predict the average annualized return from 2000-2009 which did not predict the average annualized return from 2010-2016.  All were different numbers as was the average annualized return from 1991-2016.  In my humble estimation, the average annualized return of an investment has minimal or no predictive ability.  I would suggest using any investment analytical service, fund or otherwise, to rates funds by past performance is a waste of time and money.

If I am correct that looking backwards at average annualized return is of no help, how should investors making long term investment decisions.  I would suggest the following:

  • Understand and commit to valuations.  The S&P Index had an entirely different valuation at the end of 2007 when it was high than the end of 2008 when it was low.  The average annualized return was very attractive at the end of 2007.  One year later, the end of 2008, the average annual return was lower, but valuations were significantly more attractive than the end of 2007.  Researching valuations takes time and expertise and best done working with a knowledgeable professional, however, the following may be of help.
    • Would the long-term valuations of the investment considered to be high or low?  There are criteria to determine the valuation of most investments to help determine if they are attractive going forward or becoming high risk. 
    • What will continue to drive up the price of this investment?  In other words, why will investors continue to decide to own this investment and what will drive additional investors to invest in it in the future driving up the price or market value?
    • Review 10-year valuation forecasts from reputable firms.  They do not predict or guarantee the future but do provide some basis for making long term investment decisions.
  • Understand and accept the factors governing short term volatility.  Day to day, even minute to minute, a specific investment and the market overall can be driven by short sellers and momentum investors, to name a few. Their objectives are much different than long term investors.  
    • For example, a short seller can sell shares of a stock they do not own hoping to drive the price down and ultimately buying the stock [or covering the short] at a later time which could be minutes, days, weeks or months.   For long term investors who have confidence in the potential long term of a specific investment, short sellers can create opportunity for enhanced returns by buying more shares at a lower price.  However, many investors make an emotional response to short sellers and sell their shares at low point locking in a negative average annualized return.  Again, this is an emotional response, but not a thoughtful or informed. 
  • Commit to and maintain a long-term perspective.  If there is significant decline in market value, do not panic and sell.  Instead review the investment, again probably best done with a trained professional, reflect on the initial time horizon and assess if the reasons the investment was made in the first place are still valid.

In summary, the average annualized return of any investment can change, often dramatically, but the only time it counts is when the investment is sold.  The rest of the time it is simply a picture of what the return would be the investment is sold as of the date of the picture.  In my estimation, it is not a basis for making long term decisions. 

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.