Compounded Annual Return
The compounded annual return is the rate of return on your investment taking into consideration the compounding effect of the investment for each year. This is a much more accurate measure of performance than the average annual return.
Average Annual Return
Average annual return is the return realized when you divide the cumulative return on the investment by the number of years. This calculation is used by many newsletters and financial gurus to inflate their returns.
Here’s an example of the difference between the two:
If you average just a tad more than a 14% return for each year for 5 years you will have doubled your money. And, it’s not just a 70% (5 x 14%) return, but a 100% return on your money.
The reason is that there is compounding for each year that your money made 14%. The unscrupulous will use the 100% return, divide it by the 5 years and say that you made an “average annual return” of 20%.
If we carry our example out another 5 years, you now have made a 300% return, and if you divide this by the 10 years you’ve held the investment, it appears to be an average annual return of 30%.
However, all of this actually happens by just using a constant 14% “annual compounded return” for 10 years.