How Annual Rates of Return Can Deceive You

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Mutual funds and many other types of investments publish their annual rates of return. If you're looking at a list of investment choices in your 401(k) plan, you'll see each investment’s return over the past year, then usually its three-year, five-year and 10-year annualized rate of return.

About Annual Rates of Return 

Annual rates of return can deceive you. Too many investors look at the annual return for the last year, and that is the investment they put their money into if it looks good.

Although common, this is a flawed approach to picking investments. An investment can have a great return one year and a horrible return the following year. For example, who wouldn’t want a 38-percent return? That was the approximate annual rate of return for many small cap index funds* in 2013. But these same funds had annual returns that were less than 4 percent in 2014, and in 2015 they went down 5 to 6 percent, which means they had a negative annual rate of return.

Investors who picked small cap funds based on the annual rate of return in 2013 were sorely disappointed over the next two years. Meanwhile, large-cap index funds and REITs — real estate investment trusts — did quite well in 2014. 

What About Annualized Rates of Return?

An annual rate of return shows you the return for a single calendar year. An annualized rate of return shows you the average return that was achieved over a number of years, while the annualized rate of return evens out the ups and downs.

For example, if the fund had a 38-percent return, a 4-percent return, then a -5 percent return, the average annualized three-year return was about 12 percent, which is an average of those three years. Many funds have great annualized rates of return, but that tells you nothing about what the return will be next year.

Stock funds have typically delivered higher returns than bond funds over longer periods of time, so if you're looking at annualized returns for funds that have been around for ten years or more, you're likely to see higher returns on the stock funds than on the bond funds. Yet stock funds are much more likely to have a year with a large negative annual return in the short term. 

To understand annual returns and develop realistic expectations, you have to have an understanding of what the investment is. Over long periods of time, one type of investment — such as short-term bonds — will exhibit certain characteristics. Other types of investments — like small-cap stocks — will exhibit very different characteristics. Yet there are years when they may each have an identical annual rate of return.

What to Look at Instead

Rather than picking investments based on their rate of return, consider picking investments by matching your goals with the characteristics of the investment. For example, if you're young and investing in your 401(k) plan or IRA, you want the highest long-term returns possible. Long-term means over the next 20 to 30 years. Last year’s annual return and next year’s annual rate of return are not relevant to your goals or to your investing time frame.

What is relevant is what investment type is most likely to deliver the highest returns if you stay invested for 20 to 30 years.

The answer is index funds that invest in small-cap and value stocks. No one can guarantee that these investments will have the highest returns over these long time frames, but research and history both show that this the most likely outcome.

If you're ready to retire next year and you know you'll need to take a withdrawal of about $40,000 from your 401(k) plan, the best choice for that $40,000 will be something that is stable, like a money market fund or a stable value fund. These types of choices will never deliver a high annual rate of return, nor will they have a large loss. Their purpose is to preserve your investment value while delivering some interest income.

The Key: Investing on Purpose

Professional investors do not move money into the fund that had the highest annual rate of return last year. They build a portfolio model which spells out how much of their funds should be in each type of investment: for example, 30 percent to large cap, 20 percent to small cap, 20 percent to international, 10 percent to REITs and 20 percent to bonds. Then they pick investments in each of those categories.

There are many automatic ways you can do this in your 401(k). Most 401(k) funds offer target date funds in which case you pick the fund that has a year in its name that most closely corresponds to your expected retirement year. These funds automatically invest across various categories and change the investment mix as you get older.

Another option is a balanced fund, which maintains a balance between stocks and bonds. Many 401(k) websites offer a questionnaire or tool you can use which will automatically recommend a model portfolio or selection of funds after you answer a few questions.

These types of target date funds, balanced funds and model portfolios will have annual returns that are a blended result of all the underlying investments that they own. This most likely will never result in the highest or lowest annual return, which is a good thing. Using model portfolios is a smart way to invest. It's what professionals do.

If you aren’t sure where to get started, hire a financial advisor to help you, or read a few beginner investment books such as Four Pillars of Investing and The Behavior Gap — two of my all-time favorites. Whatever you do, don’t go picking an investment simply because it had the highest annual return last year!

*My annual return numbers for the small cap index fund example are based on the performance of the Russell 2000 index with returns quoted from the DFA Matrix Book 2015.