Blogging Is Learning!
Investment and Personal Finance bloggers enjoy their craft because they don’t want to hear the sound of one hand clapping. I am no exception! Though I may be strong with my opinions at times, I am not afraid to learn from the opinions of others!
I was recently contacted by a CFA portfolio manager/analyst regarding my article on Einstein’s rule of 72. His name will be withheld until I can probably thank him for his comment, and obtain his permission to publish full details. Instead, I will paraphrase his analysis of the article for this post.
Using The Wrong Measuring Stick
The first problem with my analysis was the use of an arithmetic average versus a geometric average. The anlayst’s rebuttal was to challenge my example (Investment B) with his own scenario:
End of year 1: (0%) $100,000.00
End of year 2: (0%) $100,000.00
End of year 3: (24%) $124,000.00
This example still produced the same arithmetic average of 8% as my “Investment B” example. However, the final results are different. Calculating the geometric average or annualized annual return of the above example:
( (Ending Value / Beginning Value ) ^ (1 / # of years) ) - 1 or
(($124,000/$100,000)^(1/3))-1 = +7.43%
Widely disparate returns can heighten the difference between a geometric and arithmetic average return. For instance, my “Investment C” case study actually has an annualized return of +5.97%, not 8%. It does seem like the “rule of 72″ works just fine IF you are using the appropriate geometric average, or annualized return.
More Questions!
Short of using an excel spreadsheet function to calculate your annualized rate of return, how observant are most people to the nuances of these numbers? Did you pick up on my error in my previous post? Isn’t it still not easy to battle back from a negative-return year to stay on track for the rule of 72? How well do wild annually fluctuating mutual funds (i.e. precious metals mutual funds) follow the rule of 72? How does your advisor explain the rule of 72? Do they use arithmetic averages or geometric averages or even bother explaining the differences? There are many more questions, and I will keep blogging for the answers!
Related Posts:
- Women Financial Bloggers
- Building Your Credit Score At A Young Age
- AOL Blogging Stocks
- Are You An Investor Geek? (or The Next Motley Fools?)
