Only compounded returns can be spent, not average returns

The difference between average and compounded returns for investors is depicted in this graph.

The effect of negative numbers and the impact of uncertainty as determined by the variability within a series of returns are the two concerns examined. Both of these problems have the potential to devastate investors’ actual returns as compared to the average.

The first issue–negative numbers–is demonstrated by this example: a gain of +20% and a loss of -20% may average zero, yet the net result is a loss regardless of the order in which they occur (100 + 20% = 120 – 20% = 96 or 100 – 20% = 80 + 20% = 96).

The second dynamic–volatility–is illustrated by another example: the compounded return from three periods of 5% returns is greater than any other sequence that averages 5%.