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November 23, 2011 at 06:09 AM
“If what you know to be true, turned out not to be true, when would you want to know?”
This is a pretty profound question to ask someone on an appointment, but it is a great way to get into the truth and maybe some of the deception behind rates of return. Basically, it’s a very nice way to say to a person, “Something you have been told is simply not true.”
Of course, most people will answer “well, I’d want to know right away.” Nobody wants to admit they stick their head in the sand. Yet I ask you this, “Can the truth itself be deceiving at the same time?” The answer, regrettably, is yes.
There are two calculations that a company might use when referring to rates of return. There is the Average Rate of Return and the Real Rate of Return. What’s the difference, you ask, and how can one be seen as misleading where the other is not? Let me show you an example.
Your client puts $100,000 in an investment and in year 1 it increases to $200,000 – a 100% return. Now let’s say in year 2, it loses 50%. The value is back down at $100,000.
If you wanted to show an average rate of return over the two years, you would take the 100% return minus the 50% loss (which leaves you with 50%) and divide by two (since we are looking at a 2-year period) which leaves you with a 25% average rate of return, which sounds very impressive and desirable. However the real rate of return was actually 0% because you started at $100,000 and you still have only $100,000 after a 2-year period.
