How Consistent Returns Build Wealth
Jerry Davidse uses two hypothetical portfolio comparisons to show that an average annual return alone does not tell the full story. Because losses require larger gains to recover from, he explains how a portfolio with a lower average return but steadier results can end up creating more wealth than a more volatile one with a higher average.
Jerry Davidse uses two hypothetical portfolio comparisons to show that an average annual return alone does not tell the full story. Because losses require larger gains to recover from, he explains how a portfolio with a lower average return but steadier results can end up creating more wealth than a more volatile one with a higher average.
Key takeaways
- Portfolios with the same average annual return can produce very different ending values depending on how consistent those returns were.
- Because losses require a larger percentage gain to recover, a 25% decline needs more than a 33% gain just to break even.
- In the video's example, the portfolio with the lowest average annual return actually produced the highest ending value due to lower volatility.
- Evaluating an investment strategy means looking at risk and consistency, not only the average return, in light of your goals and time horizon.
Hi friends. When evaluating your investment portfolio, it is easy to focus on one number, the average annual return. But an average alone does not tell the full story. The consistency of those returns can have an enormous effect on how your wealth compounds over time.
Table number one illustrates this clearly. Portfolios A, B, and C each produced the same average annual return of 7%. However, the experience and the ending value of each portfolio was dramatically different. Portfolio A earned a consistent 7% per year and grew to approximately $1.3 million. Portfolio B experienced larger gains and losses and ended at about $1.1 million. Finally, portfolio C had the greatest fluctuations and finished at only $789,000. The average return of all three was identical, but the outcomes were very different.
Why? Because investment returns compound. After a portfolio experiences a loss, it must earn a larger percentage gain just to recover. For example, a 25% loss requires a gain of more than 33% to get back to where your portfolio started. The larger the decline, the more difficult the recovery becomes.
Table number two makes this point even more powerfully. Portfolio D had the lowest average annual return at 7%. Yet, it finished with the highest value, approximately $1.39 million. Portfolio E averaged 10% per year, but ended at about $1.28 million. And portfolio F had the highest average annual return at 14%, double portfolio D. But, because it experienced the greatest volatility, it finished with the lowest value, approximately $1.21 million. So, the portfolio with the lowest average return ultimately created the most wealth.
This does not mean investors should avoid all volatility or simply choose the portfolio with the lowest risk. Every investment strategy must reflect the investor's goals, time horizon, income needs, and ability to tolerate risk. The lesson is that successful investing is not only about pursuing the highest possible return. It is also about managing significant losses, staying disciplined through changing markets, and allowing consistent returns to compound for you over time.
When evaluating performance, do not only ask, "What was the average return?" Also ask, "How much risk was taken? How consistent were the results? And how much wealth was actually created?" In investing, the smoothest path may not always appear the most exciting, but it can be the most rewarding.
Thank you, and I look forward to talking with you next Friday morning.
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