You can stop trying to convince yourself that things aren't as bad as they seem.
You might be looking at your once-fabulous
Amerindo Technology fund and think: OK, the thing was up 251% last year and it's only down 37% this year. I'm still ahead 214%.
Returns don't work that way.
You cannot simply subtract the return this year from the one last year to determine your actual return. You would be ignoring a basic element of investing: compounding.
Compounding simply means that you make -- or lose -- money on the money you've already made. When you put money in a savings account, it earns interest. In addition to the principal, that interest will also start to earn interest. Thanks to compounding, money can grow more rapidly if an investment's earnings are left in your account to earn additional money.
The same idea applies to stock and mutual fund investments.
To determine what you've actually earned on an investment, you've got to take into account not only your initial principal but also the additional money you've made or lost during prior periods.
Think about it this way.
Say your fund was up 100% last year and has fallen 50% this year.
You cannot merely subtract the second number from the first to get your actual return on your investment. With that calculation, you would have made a 50% return over that period. If you invested $1,000 in that fund at the beginning of 1999, that investment would now be valued at $1,500. Pretty good, right?
Sure, except that it's wrong.
That calculation ignores the money you made during 1999 and how this year's performance affected that extra capital. (That simple arithmetic would work if you had taken all your gains out at the end of the year and started 2000 with the same initial $1,000 investment. But who does that?)
Assuming that you started this year with much more money than you had at the beginning of last year, your investment would be worth much less than you think.
Say you invest that same $1,000 in that same fund that climbed 100% last year and has dropped 50% this year.
Assuming that you didn't invest or withdraw any money during the year, your initial $1,000 investment at the beginning of 1999 would have been valued at $2000 at the end of that year.
Now the fund is down 50%. Your $2,000 is now worth $1,000 -- exactly where you started.
Your return is a big-fat zero.
Here's a real-world example. The
Lexington Troika Russia fund fell 83% in 1998 and then soared 160% in 1999, according to
. Your return looks like it would be up 77% over that period, but it's not.
If you started with a $1,000 investment in the fund (making no contributions or withdrawals), you would have had $170 at the end of the first year and $442 at the end of the second year. Your investment is actually down 55.8% for that two-year period rather than up 77%.
You can use this easy equation to calculate simple compound returns:
(1+ Year One Return) * (1 + Year Two Return) = 1 + Total Return
This equation, however, doesn't take into account any money that's being added or withdrawn from the investment.
In the case of Amerindo, an untouched $1,000 investment at the beginning of 1999 would be worth about $2,211 today, a gain of 121%. That number still looks fabulous but doesn't come close to the 214% you'd get with simple subtraction.
Another important element of compounding is volatility.
Volatility can dramatically impact your compound return. The greater the fluctuations or deviations in a series of returns, the lower the compound return will be when compared to a simple average.
Just look at the series of returns put together by
Charles Schwab's Center for Investment Research
By averaging the three different series of returns covering three time periods, you wind up with the exact same number: 13.3%.
But the averages are misleading if you are trying to figure out exactly what you earned. You must look at the compound average.
In Example 2, you can plainly see that the compound average is only 1.9% for the most volatile series of returns. With the more stable sequence of returns in Example 3 your compound average would be much higher.
This example doesn't necessarily mean that steady returns are always better. A fund that produces a nice 3% return every year won't necessarily earn you more money than some volatile but fantastic growth fund.
Don't hammer yourself over this.
When you're looking at a mutual fund's average annual return, that number is typically the annualized
return. That's at least a start.
Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.