Compound Annual Growth Rate (CAGR) versus Average Annual Return

Two of the key metrics used to measure investment returns are the compound annual growth rate (CAGR) and average annual return. In this blog post, we will explore the differences between these two and why the CAGR is often considered a more accurate measure of investment performance.

What is the Compound Annual Growth Rate?

The Compound Annual Growth Rate (CAGR) is a measure of the average annual growth rate of an investment over a specified period of time, considering the effects of compounding. Essentially, CAGR measures the rate at which an investment grows over time, while factoring in the effects of compounding.

To calculate the CAGR, you need to know the beginning and ending values of an investment and the length of the investment period. The formula for CAGR is:

CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1

For example, if an investment has a beginning value of $10,000 and an ending value of $20,000 over a five-year period, the CAGR would be:

CAGR = (20,000 / 10,000) ^ (1/5) - 1 = 15.14%

This means that the investment grew at an average annual rate of 15.14% over the five-year period.

What is the Average Annual Return?

The Average Annual Return is a measure of the average rate of return of an investment over a specified period of time, without considering the effects of compounding. It is calculated by averaging the annual returns over the investment period.

For example, if an investment had returns of 10%, 20%, and 5% in year 1, year 2, and year 3, respectively, the average annual return over the three-year period would be:

Average Annual Return = (10% + 20% + 5%) / 3 = 11.67%

This means that the investment had an average return of 11.67% per year over the three-year period.

Why CAGR is Better than Average Annual Return?

The CAGR is considered a better measure of investment performance than the Average Annual Return because it considers the effects of compounding. Compounding is the process of reinvesting the returns earned on an investment to earn additional returns in the future. By reinvesting the returns, the investment can grow at a faster rate over time.

The Average Annual Return, on the other hand, does not consider the effects of compounding. This means that it may not provide an accurate representation of the investment's performance over time, especially if the returns are volatile. For instance, an investment may have a higher average annual return over a specific period, but if its returns are volatile, the CAGR may be lower due to the compounding effect.

Another advantage of using the CAGR over the Average Annual Return is that it allows for easy comparison of investments with different investment periods. Since CAGR is based on the total return earned over the investment period, it can be used to compare investments with different investment periods. This makes it easier to compare the performance of different investments and determine which investment has performed better over the long term.

CAGR versus Average Annual Return – An Example

Let's consider an example to compare the Compound Annual Growth Rate (CAGR) and the Average Annual Return.

Suppose an investment starts with an initial value of $10,000 and grows to $20,000 over a five-year period. Here are the annual returns for each year:

Year 1: 20%

Year 2: 10%

Year 3: 5%

Year 4: -5%

Year 5: 25%

To calculate the CAGR, we use the following formula:

CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1

Using this formula, we get:

CAGR = (20,000 / 10,000)^(1/5) - 1 = 15.14%

So, the CAGR for this investment over the five-year period is 15.14%.

To calculate the average annual return, we simply take the average of the annual returns:

Average Annual Return = (20% + 10% + 5% - 5% + 25%) / 5 = 11%

So, the average annual return for this investment over the five-year period is 11%.

In this example, the CAGR is greater than the average annual return. Because the CAGR considers the effects of compounding, it reflects the actual growth of the investment over the specified time period. The average annual return, on the other hand, does not take compounding into account and may not accurately represent the investment's performance over time.

Conclusion

In summary, CAGR and Average Annual Return are both important measures of investment performance. However, CAGR is often considered a better measure of investment performance because it considers the effects of compounding and is a more accurate representation of the investment's growth over time.

Next month, we'll look at the drawbacks of Maximum Drawdown (MDD).

Get Started

0%
here
here
here
here
here
Great! Contact us for support.