The Trouble with Averages in Investment Returns

The word "average" deserves more suspicion than it usually gets. People tend to reach for averages precisely when the average flatters their case. Politicians cite rising average incomes; investment managers tout average returns. In both instances, the average can conceal far more than it reveals. Heritage Hill encourages investors to treat the word as a prompt for questions rather than a conclusion, because in the world of investment returns, averages can be actively misleading.

Why a Single Average Hides the Story

Consider average income. When you hear that it is climbing, you are invited to assume the gains are broadly shared. But the increase might come entirely from a handful of already-wealthy households growing far wealthier while everyone else stands still. Outliers pull the average away from the typical experience, and often no one actually earns the "average" amount. There are almost always more honest ways to describe a data set.

The same problem plagues investment returns, and it matters even more there because of how compounding works.

The Same Average, Very Different Outcomes

Suppose three portfolios each report a 5 percent average annual return over five years. It is tempting to conclude they performed identically. They did not.

Imagine one portfolio that swings wildly, posting a steep loss one year, a strong gain the next, and lurching around from there, but happening to average 5 percent. Imagine a second that earns a steady 5 percent every single year. And a third that sits flat for several years before a single large gain lifts its average to 5 percent. Each has the same headline average. Yet a given starting investment grows to a different ending value in each case, and the differences are not trivial. The steady 5 percent portfolio ends up worth the most; the volatile one ends up worth meaningfully less. Identical averages, different dollars.

The reason the headline figures in these examples are equal at all is that they use the arithmetic average, the method taught in grade school: add the annual returns and divide by the number of years. It is the most common way to compute an average, and for investment returns it is the wrong one.

The Hidden Flaw in Arithmetic Averages

Here is the mechanical problem. A portfolio that loses 20 percent in one year and gains 20 percent the next has not broken even, even though the two figures seem to cancel. Money that falls by 20 percent lands at 80 percent of its original value, and a 20 percent gain on that smaller base leaves you short of where you started. To fully recover from a 20 percent loss, you actually need a 25 percent gain.

This asymmetry compounds as losses deepen. Recovering from a 30 percent loss requires a gain of more than 40 percent. A 50 percent loss demands a 100 percent gain just to get back to even. And a portfolio that loses 75 or 80 percent needs a truly heroic recovery, several hundred percent, that in practice almost never arrives. This is the arithmetic reason that avoiding large losses matters so much: the deeper the hole, the more disproportionate the climb out. A steady, consistent return will build far more wealth than a volatile one that shares the same arithmetic average.

The Geometric Average: A More Honest Measure

For investment returns, the geometric average is the accurate tool. Rather than adding the yearly returns, it multiplies the growth factors together and takes the appropriate root, which correctly captures how money actually compounds year over year. The geometric average is equivalent to the annualized return: it tells you the single steady rate that would produce the same ending wealth.

Apply it to the volatile portfolio from earlier and its true annualized return collapses well below its 5 percent arithmetic average, because volatility erodes compounded growth. The steady portfolio, by contrast, shows a geometric average essentially equal to its arithmetic one, precisely because it had no volatility to drag it down. The gap between the two averages widens as volatility rises and as the time horizon lengthens. Over long historical stretches, the geometric average of the broad stock market has run materially below its arithmetic average, and the geometric figure is the one that reflects what investors actually earned.

When to Reach for the Median Instead

For data sets that are not investment returns, particularly demographic and income figures, the median is often the more truthful measure. The median is simply the middle value, and because it ignores the size of outliers, it resists the distortion that skews an average.

This is not an abstract point for real estate investors. Marketing materials for private deals are frequently dense with demographic and income statistics, and the choice of average can quietly reshape a business plan's credibility. Suppose a value-add apartment plan hinges on raising rents, and the sponsor cites an average resident income near a comfortable six figures. On that basis, a modest monthly rent increase looks easily absorbed. But if a few very high earners are inflating the average while the median resident earns roughly half that figure, the reality is different: most tenants are far more sensitive to a rent hike than the average suggests, and the plan's rent assumptions may be built on sand.

The Habit Worth Building

Treat the word "average" as an invitation to dig. When a manager or a marketing deck quotes one, ask which kind it is, arithmetic or geometric, and then ask for the median as well. Understanding the limits of averages is one of the simplest and most durable ways to separate a genuine opportunity from a well-dressed one.

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This material is for informational and educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security. Private real estate investments involve risk, including the possible loss of principal. Past performance is not indicative of future results.