Compound Annual Growth Rate vs. Average Annual Return

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I’ll be honest with you—writing this post makes me feel like Jack Nicholson’s character in the movie “A Few Good Men.” Remember when Nicholson is interrogated by Tom Cruise in the movie’s most memorable scene and Cruise demands the truth?

Nicholson replies, “You can’t handle the truth!”

So, what the heck to do with that calculation Compound Annual Growth Rate?

Well, one of the biggest mysteries in the investment industry is that mutual funds, variable annuities and countless other products tied to the stock market advertise their average return numbers in very misleading ways.

What’s worse? They are not breaking any laws by doing this.

I know…a collective gasp from everyone reading this.

What am I talking about?

Having been in the financial services industry since 2000, I’ve noticed that almost all investment product companies (mutual funds, ETFs, stock market indexes, variable annuities, closed-end funds, REITs) like to cite their “average annual rate of return.” Figures that always inflate what the particular investment actually returned to its investors. And it really bothers me.

2+2 always equals 4… except the wall cent.

This problem isn’t complicated, nor is it abstract in any particular way, (as the investment industry would have you believe) it really comes down to basic math.

Average annual return, as it’s always called in investment literature, (marketing pieces, prospectuses, etc.) is a deliberate shell game called simple arithmetic average calculation to confuse your idea of ​​return, when the only return that matters is compounding. Annual Growth Rate (CAGR).

Now, I know it sounds like I’m splitting hairs here but hang with me with an example and you’ll understand my beef.

Example: Let’s say Bill invests $100,000 in his investment account at JT Marlin (some of you may get the boiler room reference) and his account grows 25% in year 1 but the account returns a negative 25% in year 2.

The stock market muppets will say your average return is 0%…and they are telling the truth…President Clinton swore he never had sex with that woman.

But that nonsense clouds the truth—because who cares what your average rate of return was?

Year 1— 100,000 x 25% = 125,000

Year 2— 125,000 x (-25%) = 93,750

If Bill started with 100k and now at the end of two years his account is worth $93,750 his actual compound annual growth rate (cagr) was -6.25%.

But didn’t I prove in the example that his average annual rate is 0%?

So, how can Bill have less money than he started with?

Welcome to the wonderful world of investing and visionaries of Wall St.

I found this little tidbit online while looking around to see what others were talking about CAGR.

Investopedia.com says:

“CAGR is not actually real return. It is an imaginary number that describes the rate at which an investment would grow if it grew at a constant rate. You can think of CAGR as a way of smoothing returns.”

Honestly, I am speechless.

The Enron accountant has apparently taken up residence on Wall Street and is heavily engaged in publishing content for the financial media.

I beg to differ with Investopedia

Your original return is the only type of return that matters at all. What is fictional is Bill (see above) who has averaged 0% on his account over the last two years!

Totally crazy.

Who cares what I’ve “averaged” over the past two years. If my stack is smaller than when I started, it’s not a zero-sum game.

That’s the kind of talk that would kill you anywhere but Wall Street.

So, why will the investment world always quote average return numbers?

I’ll give you a minute to figure it out on your own.

Done?

Because average annual returns always look better than actual, real returns.

If you go over moneychimp.com, they have a neat tool that lets you see the numbers as they really are. You can play with different time frames, adjust for inflation, etc.

To give you a short shortcut, I’ve taken a few screenshots to show the difference in average annual return versus actual return (cagr) over the last 10, 15 and 20 years.

Compound annual growth rate
10 year average
15 year average
20 year average

The fact is that most stock market investments are volatile and showing you the average return (arithmetic average) makes them more attractive. Just look back at the pictures, they really speak for themselves.

What makes average returns so confusing is that there have been times in the market where the “average return” was positive but the actual return on your money was negative.

Who cares what the average is?

It’s like talking about a company’s total revenue…

If you own a share of XYZ Corporation, the only number that matters is net profit. Who cares if the company’s earnings are $1.25 per share but the net profit to shareholders is a penny?

Here’s a great quote.”Essay on Warren Buffett: Lessons for Corporate America“:

Over the years, Charlie and I have observed many accounting-based frauds of staggering proportions. Few of the criminals were punished; Many were not even condemned. It is much safer to steal big money with a pen than small money with a gun.

Remember what Buffett says in this quote, it applies here.

Of course, also consider that I haven’t factored in the effect that inflation has had on returns, which is another great feature of the MoneyChimp site—you can also include inflation-adjusted return numbers.

Obviously, inflation has a eroding effect on income both in real and average numbers. No big surprises there.

The really unfortunate thing about this whole situation is, I think most of the people who perpetuate this lie, have no idea that they are doing anything wrong! Calculations that ignore compound annual growth rates are so embedded that even advisors, CFPs, investment advisors, and other financial professionals spout the numbers without questioning their validity.

I can’t say that they are being deliberately dishonest but I can say that most are ignorant of the truth.

And I’m not sure which is worse?

My advice is to do the math yourself and ask lots of questions. Only then can you be confident that you have made a wise decision.

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kang digi is a freelance blogger, writer and a little bit web developer.