Do you ever wonder why the rate of return on your investment statements are lower than what the investment company is reporting to their shareholders? What is the deal? Today, we’re going to look at the math behind this. I think you will find how this works very intriguing. There is a saying, ‘The Math doesn’t lie”, but sometimes it doesn’t necessarily tell you the complete truth.
I will be sharing snapshots of my calculator and showing how the math works over a hypothetical two-year period of time. I am going to pretend that I invested $100,000 in year one. Since we are using this simply as an example, I am going to pretend that I received a 100% rate of return. You can see by looking at my calculator below that I had $100,000, and received a 100% rate of return or $100,000 in earnings, which means my account balance has gone up to $200,000 and it’s currently assuming a similar rate of return for year two.
However, if an investment is so aggressive that it can earn $100,000 in a year, that means you can also lose just as much in a year. So, in the calculator below, let’s pretend I lost 50% of my money in year two. Hypothetically, I had $200,000 from the year before, but I received a net earnings rate of - 50% which is a loss of $100,000, which means I’m back to my original balance of $100,000.
This is where it gets snarky. Let’s look at the average annual rate of return on the calculator below. Wait a minute! This says the average rate of return on this investment is 25%. Yet, you and I know that our actual rate of return is 0%.
Wait a minute. How can that be? Let me do the math.
100% rate of return year one - 50% rate of return year two = 50%
50% / 2-year period of time = 25%
That’s a 25% rate of return over 2 years annualized. So, their math is true. This is the math that is shared with the regulators because they are allowed to report that there was a rate of return of 25% average over those two years even though you realized a 0% rate of return by the end of year two.
It only gets worse. If this is a very aggressive fund, you know it also has to have very aggressive expense/administrative charges to be able to manipulate the fund enough to get a 100% percent increase in that first year. So, I am going to say that the fees are 3% annualized in the calculator below. You can see that in the first year that cost me $6,000 in fees. The second year, it cost me $2,487 in fees.
It gets even worse. If you are able to invest $100,000, you are probably a high-income individual. Between federal and state, let’s say your overall tax bracket was 30%. This means that in that first year, you received a tax bill for $28,200. So, your actual net internal rate of return based on fund performance, fund expenses, taxes owed was an actual net internal rate of return of - 10.33% (shown below). Yet, the performance for this investment is being reported as an average rate of return of 25%.
Have you ever seen this math before? This may be one of many things that you just don’t quite understand about how your investments work. Would you like to know what your numbers really are? If you’re ready to learn, now’s the time to schedule your Financialoscopy®.
