Based on conversations we've had lately, it seems like it's that time of the year again to dive into the differences between CAGR (Compound Annual Growth Rate) and Average Annual Return (AAR). iQUANT relies on the more accurate CAGR, while many traditional investment products and SMAs (Separately Managed Accounts) tend to focus on AAR.
The Scenario: A Gain and a Loss
Let’s break this down with a simple example. Imagine your client starts with a $10,000 investment. In the first year, the investment grows by 50%, increasing its value to $15,000. But in the second year, it faces a 50% loss, bringing the value down to $7,500. This example perfectly illustrates the difference between CAGR and AAR.
CAGR: The Real Story of Growth
CAGR, or Compound Annual Growth Rate, is all about showing the true, steady growth rate of an investment as if it increased at a consistent rate each year. It’s the metric that iQuant uses to give a realistic view of how investments perform over time, accounting for the compounding effect that really drives portfolio growth.
Example Insight: Even though the investment gained 50% in the first year, that hefty 50% loss in the second year means the investment’s actual value dropped to $7,500. CAGR reflects this by showing a negative growth rate (-13% per year), highlighting that despite the initial gain, the portfolio ultimately ended up lower than where it started. This approach gives a more accurate picture of what the investment truly experienced.
Average Annual Return: A Different Perspective
Now, let’s look at the Average Annual Return (AAR), which is widely used by many investment products and SMAs. AAR simply averages the yearly returns without considering the effect of compounding. In our scenario, it would calculate a 0% average return—adding the 50% gain and 50% loss and dividing by two.
Example Insight: The Average Annual Return implies that the investment broke even, even though it actually lost value overall, dropping from $10,000 to $7,500. This illustrates how AAR can often provide a skewed perspective, particularly in cases of significant market swings.
Why CAGR Provides a Clearer Picture
CAGR is more reliable for assessing long-term growth because it factors in the compounding effect, which is crucial in evaluating an investment's true trajectory. It smooths out the ups and downs, offering a consistent measure of performance over time. On the other hand, AAR might suggest stability or even growth in situations where the actual portfolio value has decreased, making it less dependable for gauging true performance.
Key Takeaway for Advisors
Given that iQUANT relies on CAGR to reflect the compound growth of investments, it’s essential to recognize when and why this metric is used. While AAR has its place in evaluating short-term gains or the general trend of SMAs and other investment products, it’s crucial to cross-reference with CAGR for a complete and accurate analysis of portfolio performance.
These insights help you guide your clients with more precision, setting realistic expectations and aligning investment strategies with their long-term financial goals.