Below is an illustration of the difference between simple average returns and compound returns, as well as the impact of losses no matter when they occur. Each Manager (A through F) had a different investment approach and therefore, performed differently in each of the three years. The table represents the different returns year-after-year over a three-year period for six separate managers.
Client A | Client B | Client C | Client D | Client E | Client F | |
Year 1 | 10.0% | 6.0% | 16.0% | 30.0% | 45.0% | 55.0% |
Year 2 | 10.0% | 10.0% | 10.0% | -20.0% | -30.0% | -35.0% |
Year 3 | 10.0% | 14.0% | 4.0% | 20.0% | 15.0% | 10.0% |
Simple Average | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% |
Compound Returns | 10.00% | 9.95% | 9.89% | 7.66% | 5.29% | 3.49% |
Ending Value of $1 Million Invested | $1,331,000 | $1,329,240 | $1,327,040 | $1,248,000 | $1,167,250 | $1,108,250 |
In each case, the simple return over the three years is 10%, whereas the compounded return (the amount of gain you have realized) fluctuates between a high of 10% and a dismal 3.49%. Despite the larger returns in some years, the investment is more severely impacted by the loss. Interestingly, as the size of the loss increases, a greater percentage gain is required to restore the account back to breakeven. In short, it is important to understand that managers can brag about simple averages but you can only spend compound returns. Our goal is to execute investment strategies that capture the most of bull markets while preserving gains in bear markets to provide superior long-term compound returns.
*While our rule of thumb for investing is "don't lose money", investments have the potential for negative returns over both the short and long term. Our goal, however, is to limit the downside through security selection, asset allocation, diversification, and the use of active risk management, including the use of options and contra-funds.
Compound returns are a reference to the cumulative impact of gains or losses on your portfolio, they are a reflection of your ability in your investing and they are indications of how much money is in your account. Simple returns, on the other hand, are the returns that occur each day, month or year and are only a snapshot look at an investment's performance without regard to its history.
For example, if a portfolio is down 10% one year and up 10% the next, the simple return on this portfolio is 0% and the manager can report a "break-even" performance over these two years if he refers to his simple returns. However, when it comes to compound returns, which reflect the net effect to your account, the portfolio is actually down 1%. The loss in year one reduced the amount of capital invested for the following year and therefore, a higher performance was needed simply to return the investment to breakeven. It would take an 11% gain to make up for a 10% loss, regardless of the order of the gain/loss.
