July 29, 2009

Comparing Two Investments

Lets say you were offered two investment choices either A or B as follows:

Option A

You get 5% fixed interest on your investment for a 10 year period. You might get this kind of investment with a CD or a bond.

Option B

You get 10% interest 9 out of 10 years but one year you see a 40% drop in your investment. The average annual rate is 5%. The average of +10%, +10%, +10%, +10%, +10%, +10%, +10%, +10%, +10% and -40% is +5%. I don't think anyone out there sells investments like this. But its theoretically possible that you could see this kind of return trend in a stock market investment.

If you put $1000 into each of these options which do you think would give you more money in the end?

Surely the annual average rate of 5% is going to give you the same amount in the end compared to the fixed 5%, right? No, you might have guessed that this is a trick question. In fact that 40% drop really undercuts all your growth. While the annual returns might average to 5% you're losing much of your compound growth and its harder to dig out of a hole.

With option A you would have $1,629 after 10 years. Option B would leave you with only $1,415.

The compound annual growth rates are option A : 5.0% and option B : 3.5%.

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