Unpacking the Intricacies of Rate of Return on Investments
Regarding investment decisions, one question reigns supreme: “What is the rate of return?” The answer you get essentially depends on who you consult. Pose this question to an investment broker, and you might hear that the average rate of return on an XYZ mutual fund is 6%. However, what most investors are keen on understanding is not the average but the actual rate of return.
Average Return vs. Actual Performance
The distinction between these two lies in how they account for losses. In the realm of average returns, gains and losses are treated with equal weight. Here’s a simplified example: if your investment experiences an increase of +50% one year and a loss of -50% the next, you would assume the average yield is 0%. But is it? Let’s say you start with $100,000. A 50% gain takes your balance to $150,000. A subsequent 50% loss reduces it to $75,000. If you scrutinize these numbers, you’ll realize your actual rate of return is -25%, a significant deviation from an average of 0%.
A Case Study: Fixed Indexed Annuity vs. S&P 500
To further illustrate this, let’s consider a fixed-indexed annuity with a top-rated company that offers 54% of the upside of the S&P 500 Stock Index with 0% downside risk, using a principal of $100,000. We will compare it to an investment that follows the S&P 500, which comes with 100% of the gains and 100% of the losses. The comparison spans from 1998 to 2017.
With all its ups and downs, the S&P 500 returned an average rate of 6.7%. On the other hand, the fixed indexed annuity, with its partial participation in the S&P 500 gains but zero downside risk, returned an average rate of 5.97%. At a cursory glance, it seems like the S&P 500 outperforms. But let’s delve into the account value.
The ending value of the full-risk S&P 500 account is $275,507.76. In contrast, the indexed annuity account grows to $311,162.85 despite its capped gains. The difference? A whopping $35,655.09 in favor of the annuity. The actual rate of return for the 100% S & P 500 is 5.2%.
Market Risk and Investment Choices
The guaranteed return of fixed-indexed annuity looks increasingly attractive in an era of market volatility and diminishing hopes of significant gains. Why would anyone risk sleepless nights worrying about the next market downturn when products that offer guarantees against market risk are available?
The rate of return is a nuanced metric. The average figures quoted by brokers may be misleading, obscuring the more tangible and often sobering reality of the actual rate of return. As illustrated by the fixed indexed annuity example, sometimes opting for a seemingly lower return with less risk may yield greater long-term rewards. Therefore, understanding the intricacies of the rate of return may make all the difference in making sound investment choices.
Don’t rely on average rate figures; take the time to analyze the actual rate of return and what it means for your long-term financial stability. Talk to a trusted financial advisor today to explore your investment options that offer a balance of growth and security.
- Rate of Return: The critical factor in investment decisions varies based on average returns and actual performance.
- Average vs. Actual Return: Average return treats gains and losses equally, but actual performance provides a more realistic outlook, especially considering losses.
- Fixed Indexed Annuity: Provides a share of market gains (e.g., 54% of the S&P 500) but offers 0% downside risk, serving as a safer alternative.
- Case Study: A comparison between the S&P 500 and a fixed indexed annuity from 1998-2017 showed that the latter yielded a greater account value despite a slightly lower average rate of return.
- Market Risk: In a volatile market, fixed-indexed annuities may offer security and decent returns, making them an investment worth considering.
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