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The "Financial Planning Blueprint" Blog

  • Writer's pictureJason Flurry, CFP

How to avoid the Rate of Return Trap

Learn how to REALLY make your accounts grow more consistently

Let me ask you a question. Which number is more important to you as an investor, your rate of return or the balance in your accounts?

Now if you’re like a lot of people, you probably answered “Both!” And you’re right, they are both important.

But in the long run, which one is more important to your success and financial security – rate of return or the balance in your account?

Hopefully you said the balance in your account is most important… because it’s really hard to spend rate of return at the store!

So, if we can agree that the balance in your account is the most important indicator of your financial success, then why do so many people chase investment returns instead of focusing on strategies that make the balance in their account grow more consistently? Could it be that the whole mindset of keeping score with rate of return is a trap? The answer is yes, it is a trap. Now let me show why that’s the case.

Understanding how the game is played Many investment managers compete on their investment performance because it helps them earn clout and qualify for big bonuses when they hit a winning streak. But during those times when the markets aren’t so generous, which can be every few years or so on average, what happens to your balance is far more important than your rate of return.

Look at the examples here with two investors who each have $100,000 to invest. Investor A is chasing returns and Investor B is also interested in getting good returns, but he is more conservative in his approach to help minimize risk. The market’s volatility works against them in the first year, but comes roaring back in year 2 allowing each one to break even on a rate of return basis.

So with the same rate of return, they should have the same amount of money in their accounts, right? Let’s see.

The more conservative investor has more money in his account because he didn’t have as deep of a hole to climb out of as Investor A. The rate of return was the same, but one investor was in much better shape than the other based on how their money fared. Which one would you rather be?

Any way you look at it you see the same thing While that example is interesting, no one wants to just break even. So let’s look at the same investors with a more favorable market scenario. In this case, the more aggressive investor averages 10%/yr. for the two years he’s invested while the more conservative investor only make 2%/yr. on average for the same period.

With such a big difference in the returns now, Investor A should most definitely be in a better place than Investor B, right? Well, see for yourself.

The more conservative investor won again because he didn’t have to make up for lost ground like his more aggressive counterpart. His money was able to start growing faster and the rate of return had very little to do with his success. The key to making his approach work was aligning his strategy with the appropriate amount of risk to suit his goals. Taking additional risk to chase rate of return is just that – risky. And studies show that taking additional risks add no any additional value to your accounts over time. In fact, as you can see here, it can actually work against you in a very costly way.

The Rate of Return Trap can leave you feeling like you’re missing something even when you think your investments are doing well. You have to look deeper to see how your risks are balanced in order to truly become wealthy. I’ll be discussing this in more detail in my upcoming book, but you can get more insight on this and other wealth building topics in the meantime by requesting our free report here.

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