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 or an annual average return.
For example, if an investment states that last year it had a one-year return of 9 percent that usually means if you invested on January 1, and sold your investment on December 31, then you earned a 9 percent return.
If the investment states that it had an 8 percent 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 percent a year.
However, during those ten years, one year the investment may have gone up 20 percent and another year it may have gone down 10 percent. 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 1926–2015, historical stock market returns, as measured by the S&P 500 Index, averaged 10 percent a year. But that average encompassed years where it was down 43.3 percent (1931) and up 54 percent (1933), as well as more recent years like 2008 when it was down 37 percent, and 2009 when it went up 26.5 percent*.
This variation of returns from the average shows up as sequence risk. 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.
Rolling Returns Offer a More Comprehensive View
Rolling returns provide a more realistic way of looking at investment 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, etc.
The same investment that had a ten-year average annual return of 8 percent may have a best ten-year rolling return of 16 percent and a worst ten-year rolling return of -3 percent. If you are retiring, that means depending on the decade you retired into you could have experienced a 16 percent a year gain on your portfolio or a 3 percent 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. This graph of past rolling returns for various stock and bond indexes illustrates 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.
*Returns sourced from Dimensional Fund Advisors, Matrix Book 2016 p. 14–15.