The Investment Scientist

Can You Lose Money on an Investment With a 20% Average Annual Return?

Posted on: July 18, 2021

Sure you can! Look at the following stylized example.

Hedge Fund A has a first-year return of 100%, and a second-year return of -60%. The hedge fund’s average return is (100-60)/2 = 20%. But if you have invested $100k in this hedge fund, by the end of the second year, you will only have 100*(1+100%)*(1-60%) = 100*2*0.4 = $80k. In other words, Hedge Fund A gives you 20% average annual return, but you still lose $20k or 20% of your money!

What gives?! Let’s look at the following 6 investments, all of which have a 20% average return. Some are profitable and some are not. All assume an initial investment of $100,000.

Note that calculating the average return is simple:  year 1 return plus year 2 return divided by 2. The return variability is simply the difference between the year 1 or year 2 return from the average return. 

Now study the table carefully and answer the following questions:

Can the average return tell you if you make or lose money?

Can the average return tell you how much money you make or lose?

What else determines if you make or lose money?

Why do hedge funds love to use average returns?

Why do I use asset class diversification to reduce client portfolio return variability? (Note that this will make the return number look smaller.)

I’d love to hear your thoughts before I give you the answers in the next newsletter. 

Schedule a 2nd opinion financial review, buy my wealth mgmt books on Amazon.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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