I’m sure you’ve heard of the term average annual returns. Unfortunately, the term is incredibly misleading.

Average annual returns are a LIE!

In fact, you should almost NEVER look at a fund’s “average annual return” if you are trying to understand what to expect from your investment. It is so misleading.

I will show you an example later of how the average return over a time period is positive but investors actually lost money.

Today, we’re going to look at:

The difference between average returns and annualized returns for an investment fund

The huge difference it makes over many years

On the go? Watch this video instead:

Let’s get into it!

The situation where you can expect this metric to pop up is when you are comparing investment funds, which is very common.

Most people don’t have the time or the expertise to construct their own diversified portfolio or research what companies are in a prime position to pull ahead or crash.

So in that situation, it is wise to invest passive index fund or a hedge fund, but how do you pick a fund?

Between index funds and hedge funds in the US alone, there are literally thousands. So naturally, you want to compare the past performance of the different funds to see which one is the best.

New investors who are not familiar with “annualized return”, are searching “average return” on Google. As a result, average return gets way more traction on investing websites and gets used incorrectly.

As an example, let’s use the most popular index fund on the market: the S&P 500.

S&P 500 Annualized Return falsely labeled as “average annual return” from Nerd Wallet

When I type into Google “average annual return of S&P 500”, the very first result I get is a page from Nerdwallet. After scrolling down a bit, we can see a table where in this they show the 5, 10, 20, and 30-year average annual return.

The only issue is that they have not calculated the AAR, they have calculated the annualized return.

And here is an article from Investopedia titled “S&P 500 Average Return” where they describe average annual return as a vital tool for investors.

Average Annual Return suggested as a “vital tool for investors” on Investopedia

When in reality, it’s incredibly misleading, and here is why.

Everyone is very familiar with averages. If you are looking at a marathon, whoever has the highest average speed will win the race. It feels like the same concept would work for investing.

The fund with the higher average return should make me more money right?? Not the case.

The higher average return does NOT always mean more profit.

And that is a huge problem because generally when you are looking to invest in a hedge fund or an index fund, it’s most likely a retirement account like a 401K or IRA. These are investments that get held for decades and they absolutely have negative years from time to time.

The problem boils down to this, negative returns hurt your end result much much more than it affects the average.

So negative returns do not get factored in properly. Let’s get into some math!

Image of author illustrating “average annual return” of an investment

The simplest example to illustrate this point is a fund that is two years old. In year one, the fund returns a staggering 100%. But then in year two, the fund loses 50%!

When we calculate the average annual return, we do 100 – 50 = 50, then divide that by two and we get an average annual return of 25%!

That sounds amazing, right? You can probably see where I’m going with this.

If we look at how this actually plays out, you end up making $0 after two years.

Image of author illustrating “average annual return” of an investment

Say you start out with $100. After 100% return you are up to $200 (should have sold) then after losing 50% the next year you are back down your starting point, $100.

This perfectly illustrates what I said earlier: a higher average return does not necessarily get you more profit.

If you had put your money in a high-yield savings account instead for two years with an average return of 3%, you would have profited about $6.

In this case, an average annual return of 3% beats an average annual return of 25%.

I can even show you a situation where the average annual return is positive and yet you lose money! Check this out.

Image of author illustrating “average annual return” of an investment

Just add one more year to the previous example. In year three you lose another 20%. So year one 100% gain, year two 50% loss, and year three 20% loss.

That brings our average to (100% – 50% – 20%) / 3 which is 30% / 3 years which comes out to an average annual return of positive 10%.

But in reality, after giving this fund your money for 3 years, you end up with a loss of 20% – from $100 down to $80.

It’s easy to see how misleading this metric is.

So the question is, what metric should you look at?

The answer is annualized returns.

That way, the compounding nature of market returns can be accounted for.

Let’s use the 3-year example from before, but this time, we will use this equation for calculating annualized returns.

Starting value: $100, ending value: $80 after three years. This results in an annualized return of -7.17%.

Clearly, this metric more closely describes the reality of the three-year fund over the average annual return of 10%.

But wait, there’s more! Let’s consider a fund that has an incredibly long history like the S&P 500. This Index fund has been around since 1926, nearly 100 years!

S&P Historial Return in nearly 100 years

Now you could calculate the annualized return over the lifetime of the fund, and that wouldn’t be the worst thing.

But, if you look at this graph, you can see that even though the overall result is very positive, there are still long spans of time where you would see a negative return.

For instance, if you invested at the height of the market in 2000 just before the pop of the dot.com bubble, it would be about 7 years before the stock market returned to the same level.

Then we saw the housing crash in 2008 and the market would take roughly 5 more years to recover after that.

So if you invested one lump sum in 2000, you would go roughly 13 years with very little return.

I say all this to illustrate that not all time periods are equal. Depending on the time period you look at, the annualized returns could be very different.

Since you are, presumably, a mortal human who can not invest for a whole century, you are gonna want to know the probability of going negative for many years. This is AVERAGE ANNUALIZED RETURNS come in.

## Average Annualized Returns

Let’s say you want to know what to expect should you invest in a fund for 30 years. You would calculate the annualized return over a 30-year period, for ALL the 30-year periods in the history of the fund and average them all together.

On top of that, there are other valuable calculations that you can do with that information to give you a better picture.

Here is a TOOL that I like to use to analyze the S&P 500. Not only will it do the average annualized return calculations for you, but it will also calculate things like standard deviation and confidence intervals.

## Standard Deviation

Without getting into a whole lesson on statistics, standard deviation just gives you an idea of how much you can expect results to vary from the average.

For instance, let’s say you have two funds with the same average annual return, but one of them has crazy ups.

The crazy one would have a high standard deviation.

The other fund is very consistent and goes up a little bit every year; that fund would have a very low standard deviation.

## Confidence Interval

The confidence interval calculation is a useful tool as well. It tells you how likely it is for you to exceed different levels of annualized returns over the time period you selected.

Let’s say you want to put some money in a given fund for 10 years and plan to withdraw for an important purchase, like a house, and you really don’t risk going negative.

S&P 500 Confidence Interval

You can use this calculation to determine how likely it is for you to lose money.

If we look at the S&P 500, you can see historically, 90% of all 10-year timespans exceeded an annualized return of 3.4%.

This means that, according to past performance, you have a 90% chance to make over 3.4% which I think is very good.

Now don’t confuse this with a crystal ball, but it is a good starting place for you to analyze your investing timeline.