Long-term investors need to be concerned about personal annualized return – the return on their money over the entire period of the investment.
When investing in guaranteed investment certificates (GICs), your annualized return is known when you make your investment. For example, you buy a five-year GIC that pays three per cent so you know your return will be three per cent annually.
With variable-return investments such as stocks, exchange-traded funds (ETFs) or mutual funds, you don’t know what your return is going to be. To estimate what it might be, we tend to look backward. While the past can be an indicator of what might happen in the future, it’s just a guideline and shouldn’t be strictly relied upon as an indicator or promise of future returns.
Be aware that some ETF and mutual fund promoters will advertise a fund’s past performance in a way that almost makes it seem that’s the expected performance going forward. This type of advertising can be very misleading. Be sure to read the fine print if you see a variable-rate investment such as an ETF or a mutual fund advertising what looks like a promised future return.
This can also happen with investments that provide a return of capital (ROC). Some investments will pay a fixed monthly amount; it might seem like it’s income but in fact it could just be that they’re returning to you a portion of your capital each month. If the investment happens to earn the same amount they’re paying out, then there’s no issue. But sometimes the investment won’t earn as much as they’re paying out. When this happens, the price of the investment drops in value, to account for the capital they’ve paid out.
Also, when looking at returns of variable-rate investments, it’s very important to examine annual or monthly returns and to look for constancy. There’s a big difference between an annual return and an annualized return. An annual return is what an investment did each year; an annualized return is the average of those returns.
When looking at the past performance of variable-return investments, you should examine annual returns and annualized returns.
While comparing annual returns to annualized returns makes little difference if you invested your money and ignored it, that’s not what we tend to do as investors. If your annualized return was seven per cent over a five-year period, it makes very little difference what the annual returns were – as long you hold on to the investment, you would get the annualized return over those five years.
But say the annual returns varied, as they tend to do with variable-rate investments. In the first year, the investment lost money, and you panicked and sold. Then the next year the investment went up and you purchased it again. Your annualized return would not be the same as the published annualized return at the end of the five years. That’s because your time in the market was not the same as the published returns.
Missing even one good day or one good week in the market could have a disastrous impact on your return over the long term. Similarly, missing one bad day or one bad week would increase your returns substantially.
You could see an investment that has an annualized return of seven per cent over the last five years. It’s highly unlikely that the investment did seven per cent every year unless it was a GIC (and those days are long gone). It’s far more likely that the investment had returns each year around the seven per cent mark, with some years higher and some lower or even negative.
Ultimately, it’s a matter of buyer beware – again, it’s all about the return over the entire period of the investment.
Bill Green is an hourly financial and estate planner, public speaker and author of The Success Tax Shuffle. Bill has more than 26 years of experience in the financial services industry.
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