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Complexity of products

This simple yet not very sophisticated example will elude us to one of the massive problems that exist in today’s marketplace.

Take the unique and almost impossible to occur example (used intentionally for ease of math)

year by year return

year 1=100%

year 2=-50%

year 3=100%

year 4=-50%

At the end of this example, no matter what dollar of currency amount you would have began with, you would have ended up with exactly the same amount.  This is a pretty simple and easy to see math problem, gaining 100% in a time frame and then instantly losing 50% creates a lot of movement but nothing at the end of the day.  However, as you will also see, if you add the 4 years returns up and divide that number by 4, the average rate of return was actually rather different; 25%!  So, moral of the story, actual returns and average returns are two totally different things.  This problem or type of situation is very simple in the way that we describe it here but it gets magnified many times over in many different situations in the real market.

Financial products have become overly complex these days.  There are thousands of funds, stocks, ETF’s, bonds, scams and other opportunities out there and they all work different and use different assumptions to generate their return assumptions.  This seems simple but how everything fits together is vitally important.

 

Disclaimer:  All investing involves risk including loss of principal. This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.