A mentor of mine years ago, bet me lunch that he could prove that a 6% annualized rate of return could
be more than a 10% annualized rate of return. Numbers don’t lie, right? I took the bet, lost and bought
him lunch. Was I hustled? In a way, I was; but, not by him, but by the numbers and this is how the
public is hustled almost every single day without ever realizing it. Let me show you what happened.
First, Let’s look at the 10% annualized rate of return example:
We’ll begin with $1,000. The first year, let’s pretend your investment provided a 40% gain; then the
next year it had a ?20% loss. Here’s the math: 40?20=20. Take the twenty which you received over the
two?year period of time and simply divide it by the two years you held the investment and you’ll see
that your average annual return is 10%. (20/2=10)
Now, let’s look more closely at the details. I have $1,000. The first year, the value went up 40%. That
would give me $1,400 after the first year. The next year I have a 20% drop. If we take 20% away from
the $1,400, I would now have $1,120.
Now here's my second example using a simple compounding of a 6% annualized rate of return.
We’ll begin again with the original $1,000.
If I have a 6% rate of return on that investment during the first year, I’ll have $1,060.
If that money grows another six percent the second year, I will now have $1,123.60. For simplicities’
sake, let’s call it $1,124.
You tell me, which is more ? the six percent which gave us $1,124 or the 10% that gave us $1,120?
Here’s the take?a?way, be very, very careful when you compare numbers and rates of return; or you
might be losing more than just paying for someone else’s lunch.
And for those who are wondering, the average annual rate of return of the 10% investment, using a
fancy software program here at the office, I computed the ‘actual’ annualized rate of return to be
5.83%. Less return, but a whole lot more volatility and for what?
