Home > Uncategorized > Rates of Return are False Information

Rates of Return are False Information

December 11, 2012 Leave a comment Go to comments

The amount of data available about markets is a modern innovation that allows us to quickly dig into any corner of the financial world and feel like we know something about it. All too often that feeling is wrong as we get confused by imaginary trends in random noise or focus on the wrong information. But you don’t need to go into the greek letters to find numbers that do more harm than good. Even something as simple as a rate of return can be very misleading.

Most of the time, a rate of return translates to a rate of growth. It’s easy to calculate and it sounds simple and descriptive. The only problem is that it tells us what has happened already in a situation that will not repeat itself again which isn’t very useful.

Take Apple’s market cap which is $500B today. 5 years ago that market cap was $182B. Both of those numbers were determined by generally good reasons. 5 years ago Apple was selling a good number of iPods and had just started selling the first iPhones, making it a fairly valuable company. Now it defines the smartphone market and the number of models and the total sales have shot up, making it one of the most valuable companies today (though it may still be overvalued).

Based on those factors it’s fair to say that Apple went from being a mid-market large cap to being at the top of the range. The fact that its market cap went from $182B to $500B in 5 years is very clear. If you calculate the growth rate on that, the market cap grew at a rate of 22%/year in that time. That is also true but it’s much less helpful.

A growth rate implies a constant progression, making it seem like it’s natural for Apple to grow at 22%/year. But just a small shift like measuring 2006-2011 instead of 2007-2012 changes that result a lot, giving a different growth rate of 33%/year even though 80% of that was in the same period.

The underlying number, the market cap, is approximately right in each of those years based on many factors. Management at Apple worked hard to change those factors, causing the market cap to increase to a higher level. But the growth rate we calculate from that is mostly accidental and doesn’t have a deeper meaning.

In the end a growth rate can be very accurate but almost meaningless. There are so many conditions that led to that specific growth rate, it is most likely just a one-time event. Attempts to forecast the future based on a constant growth rate are more likely to be wrong than right. Like fish in a pond, businesses will dart from one point ($182B) to another ($500B) and then quickly change direction. Expecting them to go in a straight line is not a reliable way to predict the future.

This applies to other areas such as your portfolio. If you hold a certain selection of stocks 20 years from now, they will have some value on Dec 31, 2032. That future value, the price you bought them at, and the length of time you hold them will determine the rate of return you experience. Since each of those 3 parts can vary, the rate of return varies quite a bit based on small changes. Starting from the current value and adding a historical rate of return to determine the future value can sometimes be a useful guess at the unknowable but it’s a very limited forecast and is often used where it isn’t very predictive.

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