For DIY investors it can get complex to understand the various ways in which investments or investment managers report their rate of return (ROR), especially if you have a day job and don’t spend all of your time digging in on these figures.
In this blog we unpack the difference between an average and compounded annual rates of return and why they may be used to communicate different things about the investment vehicle and it’s growth potential.
Compounded Annual Return
The easiest way to describe Compounded Annual Return is the rate of return on your investment taking into consideration the compounding effect it’s growth for each subsequent year. If you’re more familiar with business reporting, this is a synonym for Compound Annual Growth Rate, or CAGR.
Although it can look (or sound) confusing, it makes sense to factor in “growth on growth” because it’s very rare that you would withdraw gains as they come in on something like your retirement plan, which you hope grows far beyond your initial investment.
Many would argue this is a much more accurate measure of performance than the average annual return because it matches what you would see on a statement, but what can average returns explain?
Average Annual Return
Average annual return is the return realized when you divide the cumulative return (final value) on the investment by the number of years (or number of periods).
If it sounds simple, that’s because it is! Perhaps too simple? That is the main critique of this metric, which can be exploited to imply an investment is performing better than it is over time.
Here’s an example to illustrate 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. How is it not just a 70% (5 x 14%) return, but a 100% return on your money? You compound in each year that your money made 14%.
The unscrupulous could use the 100% return, divide it by the 5 years and say that you made an “average annual return” of 20%, despite this being misleading.
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 rate of return of 30%.
Is the Rate of Return Misleading?
Average rate of return is often used by newsletters or financial gurus to inflate the appearance of their returns by failing to state that early growth plays a big role in generating those long-term results.
Off the cuff, if someone tells you an investment has an 30% average rate of return, your expectations at the end of your first year would be anchored to that benchmark, not the more realistic and nuanced measurement of a constant 14% “annual compounded return” for 10 years.
That said, CAGR is not a measurement immune to misuse. Be aware of the hype, and people promoting very high compounded rate of returns over short periods to disguise short-term return highs as indicative of long-term performance.
Insist on knowing the “compounded annual return” and evaluate the investment period that was calculated based on to assess and compare equitably. You can’t compare an average rate over 10 years to a compounded rate over 20 years and know which carries more volatility or is a better fit for your investment strategy. When in doubt, simply ask how two options are being compared.
A Note On Compound Interest
Although the examples above used positive situations where you’re investing and see exponential growth, sometimes it is easier to grasp the concept when it increasingly costs you more.
If you spend $1,000 on a credit card with 20% interest and commit to paying off $100/month, you’ll be paying over 11 months and paying around $85 in interest depending on how it is calculated. Why? Your payment goes toward interest first, then principal with the remainder calculating interest for the following month as your new ‘ending value.’
This example seems small, but for larger amounts over longer periods of time , you’ll see the effect of compounding in a big way.
This exponential nature of compounding why Albert Einstein allegedly labeled compound interest as the 8th wonder of the world. You just need to decide if you want that wonder working for or against your financial goals.
When to hire a financial advisor
If reviewing all of these acronyms and ways to measure return is feeling overly taxing (pun intended) it might be a sign your portfolio and overall financial plan have become complex enough you’d benefit from hiring a professional. If you’d rather focus on making the most of your wealth and not carrying around a financial terms glossary, Plancorp could be a good fit.
If you’re curious whether you’re on track to achieve your next big goal or if a firm like Plancorp is a good fit for you, our financial plan analysis is a great place to start.
