The Cash Flow Clock: For Retirees - Book - Page 26
The Cash Flow Clock
If a portfolio with $100,000 earns 50% in one year, then its value is now
$150,000. If it loses 50% the following year, then the average rate of return
is 0%. However, the value of the portfolio is now $75,000. It has lost
$25,000. Its actual rate of return is negative 25%.
As long as negative returns are involved, the average rate of return does not
tell the entire story. It makes things appear to be better than they actually are
and provides a false sense of security.
Since Lazy and Safe investments are guaranteed not to lose, the average rate
of return equals the actual rate of return. But for Risky investments, which
will lose at some point in time, the average rate of return is misleading.
Metrics like Alpha and Beta are much more useful in determining how
efficiently our portfolio is performing.
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