Average and Annualized Return Paradox

You have been convinced by a handsome positive average annual return as advertised in an investment instrument brochure and about to surrender your hard earned money with the hope that it will work harder for you as suggested by your agent. Wait a minute, do u have the annualized return or do u know how volatile of the portfolio?

Let's explore the table above. I listed 7 years worth of annual return data of an instrument. By summing up all the yearly figures and divided by seven, we got an average whooping 29% return. Logically, we would think this is a fruitful investment. But if you start counting from year one and starting off your journey with $10,000. By year 7, your investment only worth $3400 which is equivalent to a lost of -66% instead. Apparently the periods of loss erode value hugely, gains have to work doubly hard, first to restore the value lost and then to grow principal. If you compute the annualized gain using formula ((1 + Rate of Return)^1/N) - 1, where N is the period in years, you will get -14%. Knowing the important of calculating the annualized return or seek information of it before making decision on purchasing any investment instrument is so important,yet lot of investors choose to accept blindly the beautiful tag lines on the advertisement and recommendation by leading finance magazines is irony. Peoples need to start learning the meaning of figures or ratios being put up in the fund sheet to get self well informed. Eventually,the fist rule of investing is not to lose money.

Now you might think that average return have no reference value which is not quite true. We can use the different of annualized and the averaged to measure the portfolio volatility. The value is termed as "risk drag" .
The higher the risk drag, more volatile the portfolio.