Do you understand how Wall Street does things? I realize this will be a shocking statement, but you’ll make better decisions for your retirement plan if you know some of Wall Street's tricks. Here’s one in particular – the difference between arithmetic returns and chained returns. It’s a doozy! (I’ll have more of these tricks in the upcoming weeks.)
Arithmetic Returns vs. Chained Returns
This trick focuses on how returns are calculated and reported. You might be surprised to know that there are two methods: Arithmetic returns and chained returns. Arithmetic returns are similar to a simple average; a computation that’s probably more familiar to you. But it’s chained returns that are most important. Let’s look at two scenarios (Table 1 below) from one of my favorite books: The Capitalist’s Lament - How Wall Street Is Fleecing You and Ruining America.
The arithmetic return (Column 2) suggests that your average return is 4% per year, which is calculated by adding the previous years’ numbers and dividing by four (Add up the percentages in Column 1 and divide by 4.) With a 4% average increase per year, you might think your balance is approximately 16% (4% times 4 years), which would be higher than when you started, but that’s not the case. Due to massive performance swings, you surprisingly have $2.65 less than when you started. (You started with $100 and ended with $97.35!)
With a simple average, you’re not doing too poorly. With the chained (or actual) result – not so good. (The calculation is as follows: Take $100 and increase by 48%, decrease by 35%, increase by 15%, then decrease by 12%. You’ll be left with $97.35!)
Whatever Wall Street wants to pretend, you live in the chained world. (You lost $2.65 and, more importantly, 4 years.) This is another reason why a tortoise approach to accumulating assets is preferable to a hare approach. The tortoise wins again! If the gains and losses from years 1 and 2 were smaller, the result would have been much better.
That's just the way it works!