In my years of analyzing investment performance, I have observed a persistent and dangerous fascination with average returns, particularly when broken down into monthly increments. A client will see a fund’s advertised “average annual return of 10%” and instinctively divide by twelve, picturing a steady deposit of 0.83% into their account each month. This mental model is not just inaccurate; it is a fundamental misreading of how markets work that can lead to poor decisions and shattered expectations. The average monthly return is a statistical phantom that hides the true nature of risk and reward.
Today, I will dismantle the concept of the average monthly return. We will explore why it is a misleading measure, how volatility—the very thing averages conceal—dictates your actual experience, and what metrics you should focus on instead. This is a lesson in looking beyond the sales brochure to understand the real, often jagged, path your money will travel.
Table of Contents
The Fatal Flaw: Arithmetic Mean vs. Geometric Mean
The first and most critical concept to grasp is that average monthly returns are not additive. You cannot simply multiply an average monthly return by twelve to get an accurate annual return. This is because of the mathematical impact of compounding and volatility, a phenomenon known as variance drain.
Let me illustrate with a stark example. Imagine a fund has two tumultuous years:
- Year 1: +100% return (a doubling of your money)
- Year 2: -50% return (a halving of your money)
The arithmetic average of these two annual returns is: \frac{100\% + (-50\%)}{2} = 25\%. This sounds fantastic.
But what is the real, geometric return? If you invest \text{\$100}:
- After Year 1: \text{\$100} \times (1 + 1.00) = \text{\$200}
- After Year 2: \text{\$200} \times (1 - 0.50) = \text{\$100}
You broke even. Your actual compound annual growth rate (CAGR) is 0%. The volatile swings, even though they averaged +25%, erased all gains.
This same principle applies to monthly returns. A fund can have a deceptively attractive average monthly return while delivering disappointing long-term results because of the order and magnitude of those returns.
What is a “Real” Average Monthly Return?
Despite its flaws, we can examine typical monthly return ranges for context. It is crucial to remember these are long-term geometric averages annualized and then broken back down, not arithmetic averages of monthly data.
Table 1: Historical Geometric Average Monthly Returns (Pre-Inflation)
| Asset Class | Approx. Annual Return | Approx. Geometric Monthly Return* | Typical Monthly Range (Volatility) |
|---|---|---|---|
| S&P 500 Index | ~10% | ~0.80% | -3% to +5% |
| US Aggregate Bond Index | ~4-5% | ~0.35% | -2% to +2% |
| International Stock Index | ~8-9% | ~0.70% | -4% to +6% |
| Short-Term Treasury Index | ~3-4% | ~0.28% | -1% to +1% |
*Calculated as: (1 + \text{annual return})^{1/12} - 1.
This table reveals the central truth: The “average” month is a fiction. You will almost never experience a month that delivers exactly the average return. The “typical range” column is where you actually live as an investor. The stock market’s returns are lumpy, unpredictable, and clustered. Periods of gains are followed by periods of steep declines. The average simply describes the center point of a wildly dispersed set of outcomes.
The Devastating Impact of Volatility and Sequence of Returns
The average monthly return tells you nothing about the sequence of those returns, which is perhaps the most critical factor for an investor, especially one who is drawing down their portfolio.
Consider two hypothetical sequences of monthly returns over a five-month period for two different funds. Both have the exact same average monthly return.
Fund A (Smooth Ride): +1.0%, +1.0%, +1.0%, +1.0%, +1.0%
Arithmetic Average = 1.0%. Geometric Return = 1.0%.
Fund B (Roller Coaster): +10%, -5%, +15%, -10%, -2%
Arithmetic Average = \frac{10 - 5 + 15 - 10 - 2}{5} = 1.6\%
Geometric Return = [(1.10) \times (0.95) \times (1.15) \times (0.90) \times (0.98)]^{1/5} - 1 \approx 1.02\%
Fund B has a higher arithmetic average but a nearly identical geometric return to Fund A. However, an investor in Fund B endured a much more stressful experience. If they needed to sell shares during one of the negative months to cover an expense, they would have locked in losses and permanently impaired their capital. This is sequence of returns risk, and it is completely invisible in an average return figure.
A More Meaningful Alternative: Examining Return Distributions
Instead of focusing on the average, sophisticated investors look at the distribution of monthly returns. This involves analyzing:
- Standard Deviation: This measures how dispersed the returns are around the average. A higher standard deviation means higher volatility and a wider range of potential outcomes. This is a better measure of risk than the average is of return.
- Skewness: Are the returns symmetrically distributed, or are there more extreme positive months than negative months (positive skew), or vice versa (negative skew)?
- Maximum Drawdown: The largest peak-to-trough decline in the fund’s history. This tells you the worst-case scenario pain you had to endure.
Table 2: Hypothetical Analysis of Two Funds with Identical Average Returns
| Metric | Fund X (Stable) | Fund Y (Volatile) | Conclusion |
|---|---|---|---|
| Avg Monthly Return | 0.8% | 0.8% | They appear identical. |
| Std Deviation | 1.5% | 5.0% | Fund Y is 3x more volatile. |
| Best Month | +4.0% | +18.0% | Fund Y has higher upside. |
| Worst Month | -3.5% | -22.0% | Fund Y has catastrophic downsides. |
| Max Drawdown | -8% | -45% | Fund Y’s risk of loss is far greater. |
This table shows that the average return is meaningless without understanding the journey. Fund Y’s extreme volatility makes it unsuitable for most investors, despite its seemingly attractive “average.”
The Investor’s Guide: What to Focus on Instead
Banish the average monthly return from your decision-making process. Here is what you should prioritize instead:
- Compound Annual Growth Rate (CAGR): This is the geometric mean. It tells you the smooth annual rate at which your investment actually grew over a specific period. It accounts for volatility and is the only return figure that matters for comparing performance.
- Risk-Adjusted Returns: Metrics like the Sharpe Ratio compare the return of an investment to its risk (standard deviation). A higher Sharpe Ratio means you are getting more return per unit of risk taken. A fund with a 8% return and low volatility may have a higher Sharpe Ratio than a fund with a 10% return and extreme volatility.
- Personal Investment Horizon: Your time horizon is the ultimate antidote to monthly volatility. The stock market has never had a negative rolling 20-year period. While past performance is no guarantee, this historical fact underscores that time smooths out the jagged monthly returns. If you are investing for 20 years, the average monthly return is irrelevant; the CAGR is everything.
- Diversification: Instead of seeking a fund with a high average return, build a portfolio of uncorrelated assets (U.S. stocks, international stocks, bonds). This will smooth out your monthly returns naturally, providing a more stable journey toward your long-term geometric return.
The Final Calculation: Embrace the Reality of Volatility
The pursuit of a high average monthly return is a fool’s errand. It is a simplistic number that masks the complex, volatile, and unpredictable reality of investing. Markets do not deliver steady, monthly paychecks; they deliver returns in unpredictable lumps.
By fixating on this average, you risk making behavioral mistakes—chasing funds that have recently had hot streaks (and are likely due for a cool-down) or panicking and selling after a string of negative months (locking in losses).
Instead, I urge you to focus on the long-term CAGR of a strategy that aligns with your risk tolerance. Build a diversified portfolio, contribute to it consistently, and ignore the monthly noise. The average monthly return is a mirage. The compound growth of your portfolio over decades is the only oasis that is real.
