I am a big advocate for deep interest. That leads to rather small portfolios.If you first ask yourself what you are interested in and then which company is the best in that area, you become a co-owner of that company, assuming you believe in their vision, their leadership team, and their standing in the marketplace.The deep interest means you don’t mind tracking what this company is doing, and because you know a lot about the business, you can detect if it is still on track towards the vision or faltering. As time goes on, you know when a temporary dip is caused by market movements, CAPEX being higher than expected, etc. By having the deep interest and the deep understanding, you will not sell and will not get to the losses Cosmo describes, and in most cases you outperform the averages, even though you only have very few companies in your portfolio.
This is really interesting. Is the compound average of a given fund or ETF something that is available or do we have to calculate it ourselves if we are interested?
Great question. You don’t need to calculate it yourself. Look for the reported CAGR, or Compound Annual Growth Rate, over standard time periods: 1, 3, 5, and 10 years. That’s the annualized return that reflects the actual compounding of your money, and you’ll find it on Morningstar, the fund’s fact sheet, or most brokerage platforms.
Where investors get into trouble is doing the mental math themselves—averaging a string of annual returns and assuming that’s what their money actually compounded at.
So keep this in mind: Your portfolio doesn’t compound the average; it compounds the sequence of actual returns. That’s where the real volatility gap shows up.
So when making projections is it more realistic to use the CAGR? With the understanding that it is merely a projection based on historical returns and they don’t guarantee future performance.
Yes, CAGR is the more realistic starting point, and you've flagged the right caveat about historical returns. But here's the deeper issue: whether you use a simple average or CAGR, holding either one steady over a multi-decade projection ignores sequence-of-return risk entirely.
The order in which returns arrive matters enormously. As we touch on in the article, the same average can lead to very different ending wealth, depending on the order of actual annual returns.
Monte Carlo simulators are just one example of a tool that attempts to address this. Rather than projecting a single return assumption over decades, they run hundreds or thousands of different return sequences, giving you a probability distribution of outcomes rather than one number. Still not a perfect answer (no model is), but far more realistic than any straight-line projection.
This is an awesome article. I guess the next step is to talk about how to reflect this into actual practice. Presumably via appropriate diversification and rebalancing? It is also worth noting that modern modeling tools incorporate these notions using Monte-Carlo and/or Historic (back-testing) mechanisms.
I would quibble with the comparison to Faxes. Faxes are still in use because the of technology concerns more than "paradigm" considerations. The Fax technology was in place long before more modern alternatives and these alternatives are still not quite as complete and/or universal in some domains such as health care.
You're absolutely right that diversification and rebalancing are the practical tools, and Monte Carlo simulation is exactly the kind of modeling that takes sequence-of-returns risk seriously. On the fax quibble: From my perspective, faxes persist because an entire ecosystem of regulation, legal standing, and institutional infrastructure was built around it, making it nearly impossible to dislodge even when better alternatives exist. That is the definition of a paradigm lock-in and the MPT parallel I was drawing. Thanks for the thoughtful feedback.
We can agree to disagree. In the medical world this is mostly about the pace of take-up of electronic records and associated communication. Other fields such as law, the "paradigm" remains document images, but fax is just a legacy approach to those images.
Thank you. The distinction between the two is one of those ideas that seems almost obvious once you see it, yet it rarely gets discussed in plain terms.
I am a big advocate for deep interest. That leads to rather small portfolios.If you first ask yourself what you are interested in and then which company is the best in that area, you become a co-owner of that company, assuming you believe in their vision, their leadership team, and their standing in the marketplace.The deep interest means you don’t mind tracking what this company is doing, and because you know a lot about the business, you can detect if it is still on track towards the vision or faltering. As time goes on, you know when a temporary dip is caused by market movements, CAPEX being higher than expected, etc. By having the deep interest and the deep understanding, you will not sell and will not get to the losses Cosmo describes, and in most cases you outperform the averages, even though you only have very few companies in your portfolio.
This is really interesting. Is the compound average of a given fund or ETF something that is available or do we have to calculate it ourselves if we are interested?
Great question. You don’t need to calculate it yourself. Look for the reported CAGR, or Compound Annual Growth Rate, over standard time periods: 1, 3, 5, and 10 years. That’s the annualized return that reflects the actual compounding of your money, and you’ll find it on Morningstar, the fund’s fact sheet, or most brokerage platforms.
Where investors get into trouble is doing the mental math themselves—averaging a string of annual returns and assuming that’s what their money actually compounded at.
So keep this in mind: Your portfolio doesn’t compound the average; it compounds the sequence of actual returns. That’s where the real volatility gap shows up.
So when making projections is it more realistic to use the CAGR? With the understanding that it is merely a projection based on historical returns and they don’t guarantee future performance.
Yes, CAGR is the more realistic starting point, and you've flagged the right caveat about historical returns. But here's the deeper issue: whether you use a simple average or CAGR, holding either one steady over a multi-decade projection ignores sequence-of-return risk entirely.
The order in which returns arrive matters enormously. As we touch on in the article, the same average can lead to very different ending wealth, depending on the order of actual annual returns.
Monte Carlo simulators are just one example of a tool that attempts to address this. Rather than projecting a single return assumption over decades, they run hundreds or thousands of different return sequences, giving you a probability distribution of outcomes rather than one number. Still not a perfect answer (no model is), but far more realistic than any straight-line projection.
If you want a more detailed discussion of sequence-of-return risk and what it means specifically for retirement planning, I wrote about it here 👇https://www.cosmodestefano.com/p/in-retirement-planning-consider-the
This is an awesome article. I guess the next step is to talk about how to reflect this into actual practice. Presumably via appropriate diversification and rebalancing? It is also worth noting that modern modeling tools incorporate these notions using Monte-Carlo and/or Historic (back-testing) mechanisms.
I would quibble with the comparison to Faxes. Faxes are still in use because the of technology concerns more than "paradigm" considerations. The Fax technology was in place long before more modern alternatives and these alternatives are still not quite as complete and/or universal in some domains such as health care.
You're absolutely right that diversification and rebalancing are the practical tools, and Monte Carlo simulation is exactly the kind of modeling that takes sequence-of-returns risk seriously. On the fax quibble: From my perspective, faxes persist because an entire ecosystem of regulation, legal standing, and institutional infrastructure was built around it, making it nearly impossible to dislodge even when better alternatives exist. That is the definition of a paradigm lock-in and the MPT parallel I was drawing. Thanks for the thoughtful feedback.
We can agree to disagree. In the medical world this is mostly about the pace of take-up of electronic records and associated communication. Other fields such as law, the "paradigm" remains document images, but fax is just a legacy approach to those images.
That’s the first time I’ve read about compound average compared to annual returns average. Really interesting read thanks.
Thank you. The distinction between the two is one of those ideas that seems almost obvious once you see it, yet it rarely gets discussed in plain terms.