What if you were told to choose from two investments:

• Investment A had an average annual return of 5.00% over a 10 year period.
• Investment B had an average annual return of 4.97% over a 10 year period. 

Seems pretty straight forward, so I'm guessing that a majority of you would select Investment A since it has a higher average return. A few of you would be thinking, "this must be a trick question" and would select B. What if I then told you that the value of Investment B was almost 50% higher than Investment A at the end of this period. Do I have your attention now?

I created a simple spreadsheet here to demonstrate how this happened:

What makes this analysis even more interesting, is that I used actual historical stock market data for the investment returns. Investment A uses returns for an S&P 500 proxy for 1928-1937 and Investment B uses data from 1966-1975. For history buffs out there, it is easy to see why those who lived through the Depression soured on the stock market. If they managed to hold on to their stocks over that ten year period, they were rewarded with a 6% loss. 

So, what's the lesson for investors?

Avoid big drawdowns (aka "losses") as they are hard to recover from (witness Year 3 and Year 4 for Investment A). Again, the math here is important. Lose 50% on an investment and you need to gain 100% just to get back to even. A simple example here: Start with $1000, lose 50% and your investment is worth $500. To get back to even, that $500 needs to double (a 100% return) to $1,000. 

How to reduce the risk of a BIG LOSS? Own a diversified set of investments (I like index funds to accomplish this) that includes both stocks and bonds and DON'T TRUST AVERAGE RETURN DATA. Or as the investment adage goes "Don't put all your eggs in one basket." 

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Looking for more engaging Investing resources? Check out the NGPF Investing curriculum page! 

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Want to find math related resources? Be sure to scan our Math Resource Directory!

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

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