Rolling Returns vs. Average Annual Returns
Past returns can be deceptive unless you know how to interpret them. Most investment returns are stated in the form of an annual return—the amount an investment returns from dividends, capital appreciation, and other sources over a period. These returns can be represented as rolling returns or an average annual return (AAR).
Both average annual and rolling returns can represent a period of several years. Most often, these will be shown as 5-year and 10-year returns. However, an annual return represents a single year or a given period of 12 months. Also, these results are annualized to represent the average of returns with compounding and the reinvesting of interest and dividends.
For example, if an investment states that last year it had a one-year return of 9% that usually means if you invested on January 1, and sold your investment on December 31, then you earned a 9% return.
If the investment states that it had an 8% annualized return over ten years, that means if you invested on January 1, and sold your investment on December 31 exactly ten years later, you earned the equivalent of 8% a year.
However, during those ten years, one year the investment may have gone up 20% and another year it may have gone down 10%. When you average together the ten years, you earned the “average annualized” return of percent.
The Danger of Using Average Returns
This average return is similar to saying that you went on a trip and averaged 50 mph. You know that you did not actually travel 50 mph the whole time. Sometimes you were traveling much faster; other times you were traveling much slower.
Nassim Taleb, in his book The Black Swan (Penguin, 2008), has a section called “Don’t cross a river if it is (on average) four feet deep.” It is a statement worth pondering. Most financial projections use averages. There is no guarantee that your investments will achieve the average return.
Volatility is the variation of returns from their average. For example, from 1939–2018, historical stock market returns—as measured by the S&P 500 Index—averaged 10.7% a year. But that average encompassed years where it was down 37.5% (1931) and up 52.8% (1933), as well as more recent years like 2008 when it was down 37.1%, and 2009 when it went up 23.1%.
This variation of returns from the average shows up as sequence risk—a hazard that a withdrawal will negatively result in the overall rate of return. You may project one outcome based on your expected average return but experience an entirely different outcome because of the volatility of the actual returns incurred.
Average Annual Return (AAR)
AAR is shown as a percentage and reports historical returns. You will see this percentage listed on equities or mutual funds where it represents the appreciation of the assets held, distribution and reinvestment of capital gains, and quarterly dividends.
The average annual return may not show how consistently an investment produces the stated percentage. Since it is averaged, it balances out poor performing years with over-performing years.
Rolling Returns Offer a More Comprehensive View
Rolling returns provide a more realistic way of looking at investment returns. An investor will be better able to highlight the strong preforming and poorly performing periods. These results are overlapping cycles going back as long as there is data—known as trailing twelve months (TTM) returns.
A ten-year rolling return would show you the best ten years and worst ten years you may have experienced by looking at the ten year periods not just starting with January, but also starting February 1, March 1, April 1, or any other date.
The same investment that had a ten-year average annual return of 8% may have a best ten-year rolling return of 16% and a worst ten-year rolling return of -3%. If you are retiring, that means depending on the decade you retired into you could have experienced a 16% a year gain on your portfolio or a 3% a year loss. Rolling returns give you a more realistic idea of what might really happen to your money, depending on the particular ten years that you are invested.
Using a rolling return would be like saying that over a long trip, depending on the weather conditions, you might average 45 mph, or you might average 65 mph. Graphs of past rolling returns for various stock and bond indexes can illustrate how different the best of times look when compared to the worst of times. All long-term investors should view rolling returns before setting return expectations on their retirement income plans.
If you use an online retirement calculator and assume you can earn a return that is much higher than what reality might deliver it could leave your retirement income in jeopardy. It is best to plan for the worst and end up getting something better than to have a plan that only works if you get above average results. You are not guaranteed only the best weather in retirement.