Wall Street Myths – Average Vs. Actual

 

Assume you started with $100,000 in your account. If your investments decreased by 25% percent one year—then increased by 25% the following year—how much would be in your account?

1. $100,000

2. More than $100,000

3. Less than $100,000

The correct answer is “C”—less than $100,000. Let’s do the math.

25% of $100,000 is $25,000—which brings you down to $75,000. Now, 25% of $75,000 is $18,750—which brings you up to $93,750.

But what if you had the gain of 25% the year before the loss? The same thing happens! Let’s do the math.

25% of $100,000 is $25,000—which brings you up to $125,000. Now, 25% of $125,000 is $31,250—which brings you back down to the same $93,750.

That fact of the matter is that for every 25% loss you incur—you must gain 33⅓% just to get back even!

In our equation most investors would say that they averaged 0% over the last 2 years. In other words +25% and -25% averages out to 0%.

The truth is if you go up (or down) 25% and then go down (or up) 25% your average return has been a negative 3.17%.

The moral of the story?  The numbers we see as ‘average’ may not accurately depict our actual return.
Here is a video that explains this concept:

 

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Josh

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