Past returns can be deceptive unless you know how to interpret them. Most investment returns are stated in the form of an annual return. This is the amount an investment returns from dividends, capital appreciation, and other sources over a period. These returns can 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. But an annual return represents a single year or a given period of 12 months. Also, these results are annualized to show the average of returns; it includes compounding and the reinvesting of interest and dividends.
For instance, let's say 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.
Now, let's say the investment states that it had an 8% annualized return over 10 years. This would mean that, if you invested on January 1, and sold your investment on December 31 exactly 10 years later, you earned the equivalent of 8% a year.
But during those 10 years, the returns were not exactly the same each year. One year, the investment may have gone up 20%; another year, it may have gone down 10%. When you take the average of the 10 years, you earned the “average annualized” percent return.
- Average returns balance out poor performance and outperformance across the timeframe being measured.
- Rolling returns are a type of average return. They average out periods within the total timeframe being measured.
- Rolling returns may offer a more comprehensive view of an investment's performance; they may may help control risk.
What Is the Danger of Using Average Returns?
This average return is like saying that you went on a trip and averaged 50 miles per hour. You know that you did not actually travel 50 mph the whole time. At some points, you were going much faster; other times, you were going much slower.
Nassim Taleb, in his book, "The Black Swan," has a section called “Don’t cross a river if it is (on average) four feet deep.” This is worth thinking about. Most financial projections use averages. There is no guarantee that you will achieve the average return.
Volatility is the variation of returns from their average. For instance, take a look at the historical stock market returns from 1939–2018, as measured by the S&P 500 Index. Over 80 years, the return averaged 10.7% a year.
But that average includes years where it was down 37.5% (1931) and up 52.8% (1933); it also includes 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. Sequence risk is the 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 you may have a different outcome because of the volatility of the actual returns incurred.
What Is Average Annual Return (AAR)?
Average annual return is shown as a percentage; it reports historical returns. You will see this percentage listed on equities or mutual funds. It represents the appreciation of the assets held, distribution and reinvestment of capital gains, and dividends.
The AAR 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 returns. You will be better able to highlight the periods of stronger or poorer performance. These results are overlapping cycles going back as long as there is data. This is also known as trailing 12 months (TTM) returns.
A 10-year rolling return would show you the best 10 years and worst 10 years you may have experienced. It will look at 10 year periods; not only will it start with January, but it will also look at periods starting February 1, March 1, April 1, or any other date.
Think about that investment that had a 10-year AAR of 8%. It may have a best 10-year rolling return of 16% and a worst 10-year rolling return of -3%. Now, what if you are retiring? That means that depending on the decade you retired into, you could have had a 16%-per-year gain on your portfolio or a 3%-per-year loss. Rolling returns give you a more realistic idea of what might really happen to your money. It all depends on the particular set of 10 years that you are invested.
Using a rolling return would be like saying that over a long trip, depending on the weather, diyou might average 45 mph, or you might average 65 mph. Graphs of past rolling returns for various stock and bond indexes can show how different the best of times look when compared to the worst of times. You should look at rolling returns before setting return expectations on your retirement income plan.
What happens if you use an online retirement calculator and assume you can earn a return that is much higher than what reality might deliver? This could leave your retirement income in danger. 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.