Calculating Interest 3: Average Return

If an investment returns 50% the first year, -50% the second, 50% the third, -50% the fourth, and 50% the fifth, you’d have an average return of 10%. To get that number, we add all the returns and the divide by the number of years. (50%) + (-50%) + (50%) + (-50%) + (50%) = 50%. Then divide that 50% by 5 years and you get a 10% return.

Not too bad, right?

But how much money will you actually have with that 10% average return? Let’s start with $10,000. If we gain 50% the first year, then our investment goes up to $15,000. In the second year we lose 50%, which brings us down to $7,500. In the third year, we go back up to $11,250, The fourth year brings us down to $5,625. And the fifth we go up to $8,437.50.

That 10% return lost us $1,562.50 ($10,000 - $8,437.50 = $1,562.50).

10% in simple interest would give us $1,000 per year, for a total of $15,000 at the end of the 5 years.

10% in compound interest would give us $16,105.10 at the end of the 5 years.

But who knows how much you’d make with a 10% average return. The absolutely best case scenario is that you’d be able to match the compound interest at $16,105.10. The worst case is you pretty much lose all your money.

So if someone says they have an opportunity that will give you a 10% return, ask what kind of return: simple, compound, or average. And be careful if they say average.

What do you think?
Joseph

This is a series. Here is the previous post. Here is the next post.