Rethinking Risk What are your returns really telling you?
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- Allan Waters
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1 Rethinking Risk What are your returns really telling you? % The word returns could mean a variety of things to your portfolio. There are several ways in which portfolio returns can be conveyed. It s critical to understand what you re measuring and why it s important. Little children like to compare themselves with their friends to see who is biggest. But what does that mean? One may be the oldest, but a different one may be the tallest, and yet another one could be the heaviest. Before they can decide who s biggest, they have to understand what they re measuring. Measuring and comparing portfolio returns can present the same type of issues. There are several ways in which portfolio returns can be conveyed. To understand what returns they are getting, it is important for investors to understand the differences between the various methods of measuring returns and the significance of what they represent. Cumulative returns show you the return on your investment from Day 1, but don t allow you to compare between investments. Average returns allow you to compare among different investments, but they reflect an investment s return, not that of the investor. They also have a long-term smoothing effect that can mask short-term volatility. Internal rate of return shows the actual return on your unique investment, but is not easy to calculate. So, just as the word biggest will mean different things to growing children, the word returns could mean a variety of things to you and your portfolio. It s critical to understand what you re measuring and why it s important. It is important for investors to understand the differences between the various methods of measuring returns. Inside, learn more about these three ways of calculating returns. Then, talk to your financial advisor to get a clear picture of your portfolio performance and how it measures up to your goals.
2 What are average annual returns? This calculation represents the standard returns for the one-, five- and 10-year time-periods that are reported by mutual fund or financial service companies. They are also a means by which mutual funds can be compared easily to an index or peers. What can be confusing is that these returns are often labeled differently among investment materials. They can be called average annual returns, average total returns, average annualized returns or the compound annual growth rate (CAGR). Regardless of how they are labeled, mathematically these returns are calculated using the geometric average. That means these returns represent the effect of gains and losses or compounding on an investment, and the results are shown on an annualized basis. Example 2 The geometric average accounts for the negative year s return on your investment value Geometric average quick calculation Ending value (+) $1,560 Divide by beginning value ( ) $1,000 Resulting value (=) 1.56 Raise to the power of 1/# of years (1/3) (X 1/3 ) 3 Resulting value (=) Subtract 1 ( ) 1 Resulting value (=) We again use our example of ABC shares that were bought three years ago for $1,000. At the end of Year 1, your investment grew to $2,000. At the end of Year 2, it fell to $1,200. Today, your ABC shares are worth $1,560. This translates into a geometric average annual return of 15.98%. The name average annual return can be misleading, because it implies that you take a simple average adding up the annual return each year and dividing by the number of years of investment. This simple average is simply incorrect. It does not properly account for negative returns and for compounding more broadly, as shown in the following example. What not to do Simple isn t always better! This example shows how a simple average calculation can give incorrect results. Year 1 return (%) 100 Subtract year 2 return (%) ( ) -40 Add year 3 return (%) (+) 30 Divide by three to get the simple average (=) 30 Why is this method incorrect? This easy back of the napkin calculation does not take into consideration the effects of compounding. Thus, the negative return in Year 2 is not accounted for properly, as it does not reflect the change in the value of the investment. Notice that this method results in a return that is significantly higher than the annual return presented in Example 2 which was correctly calculated at 15.98% and it paints a vastly different picture of the investment s actual return. That s why it is necessary to use the geometric average.
3 By the numbers How is CAGR calculated? For those who like formulas, the below illustrates exactly how we calculate the geometric average. Ending value 1 ($1,560) [ ] CAGR = [ ] # of years 1 =.1598 Beginning value (1/3) ($1,000) Example 3 Average annual returns have a smoothing effect on long term results, and can hide underlying volatility Actual returns for the fund Geometric average returns $ % $ % Initial value 1, , Year 1 2, , Year 2 1, , Year 3 1, , Ending value 1, ,560.0 Even when correctly using the geometric average calculation, average annual returns can be an inaccurate representation of how much an investment may have fluctuated from year to year. A steep loss in one particular year could be masked by a rosy longterm average. Things to consider Advantage. Average annual return is a helpful guide for measuring long-term performance, and it allows investors to easily compare different investments. Disadvantage. Average annual returns can have a smoothing effect on long term results in other words, an average can hide underlying volatility. It can be an inaccurate representation of how much an investment may have fluctuated from year to year. A steep loss in one particular year could be masked by a rosy longterm average. In Example 2, average returns show the returns of the fund not the investor. An investor s actual returns could include multiple investment dates, withdrawals and other cash flows. To incorporate those elements, we need to look at the internal rate of return.
4 What is internal rate of return? Internal rate of return (IRR) is a calculation that considers your account balance at the beginning and end of a specified period, as well as any contributions, withdrawals, growth or declines in the value of the account s assets during that time. For example, in a 401(k), money is invested every time you get paid. So this return calculation takes into account all of these different investment dates, and the different time periods in which they are invested. Example 4 We consider timed investments of $200 per week for five weeks with different starting points for each investment Internal rate of return quick look Week 1 Week 2 Week 3 Week 4 Week 5 Weekly investment amount $ Purchase price of shares $ Since stock prices are constantly changing, let s say that ABC was trading at $40 in the first week, $45 in the next week, $42 in the next week, and so on. That means each investment of $200 has a different starting point, and thus a different return at the end of the period. That s what the IRR incorporates. Things to consider Advantage. Simply put, IRR shows your actual return for your unique investment. It s the calculation that s most relevant to you and your investment experience. Since the return is specific to an individual account, it can differ significantly from the prior two return calculations discussed. Disadvantage. As you ll notice, we did not include the specific calculation for IRR. That s because it requires specialized software or a financial calculator. So, many investors will not be able to calculate this for themselves. However, your financial advisor can give you this number, and large 401(k) platform providers often have customized returns for their account holders, sometimes called your personal rate of return, which is simply the IRR.
5 What are cumulative returns? Cumulative returns express the total percentage change in the value of an investment from the time it was purchased. For example, say you purchased ABC shares three years ago for $1,000. At the end of Year 1, your investment grew to $2,000. At the end of Year 2, it fell to $1,200. Today, your ABC shares are worth $1,560. Example 1 shows that over these three years, your cumulative return in ABC stock was 56%. Example 1 Cumulative return for ABC shares at the end of three years Cumulative return quick calculation $ Current value of shares (+) 1,560 Subtract original purchase price of shares ( ) 1,000 Resulting value and gain (=) 560 Divide gain by original purchase price of shares ( ) 1,000 Resulting value (=) 0.56 Multiply the result by 100 (x) 100 Resulting value and cumulative return (=) 56% Things to consider Advantage. Cumulative returns provide you with the bottom line they show you how your investment has performed since Day 1. Disadvantage. If you look only at the cumulative return, it s difficult to compare performance across multiple investments purchased on different dates and for different prices.
6 Explore High-Conviction Investing with Invesco At Invesco, we re dedicated to delivering an investment experience that helps you get more out of life. Our comprehensive range of high-conviction investment capabilities is designed to help you build portfolios in more precise and impactful ways, and not just settle for average. This high-conviction approach is built on three core tenets: A pure focus on investing All we do is investment management. That means we are solely focused on delivering high-conviction portfolio solutions to meet your unique needs. Diversity of thought Passion to exceed Each of our investment teams is empowered to implement its own trusted investment philosophy and process. Our diverse range of capabilities allows you to create high-conviction portfolios custom-built for your needs. We are passionate about going beyond average to uncover high-conviction opportunities and provide an exceptional client experience. This material is for educational purposes only and does not intend to address the financial objectives, situation or specific needs of any individual investor. It is not a solicitation or an offer to buy or sell any security or investment product. Individuals should consult their financial advisors to learn more about the material discussed in this piece. Note: Not all products, materials or services available at all firms. Advisors, please contact your home office. This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. Past performance is no guarantee of future results. All data provided by Invesco unless otherwise noted. invesco.com/us RRRET-BRO-1 11/17 Invesco Distributors, Inc. US13362
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