Over the weekend, I was asked the difference between average annual return and compounding (or compound annual growth rate). Really, the question was, if I see a fund with a 10% average annual return, is it the same as putting the same amount in a bank account at 10% interest? I was stumped for a second, but I knew the answer was no. Here is why.
Average Annual Return
This metric is the industry standard for measuring returns of equity investments. You see it on every mutual fund prospectus. But what does it really mean?
The Average Annual Return is a percentage figure used to report a historical return of a given period (most commonly 3-, 5-, 10-year). The most common area using this figure is mutual funds.
The deceptive part of Average Annual Return is how it is calculated. It is simply (Sum of Annual Returns) / (# of Years). For example, to earn a 10% annual return, a fund could perform both of the following ways:
- Return 1: (+10% + +10% + +10% + +15% + +5%) / 5 = 10% Average Annual Return
- Return 2: (40% + +30% + -10% + +5% + -15%) / 5 = 10% Average Annual Return
If you were an investor, you would prefer Return #1, since it is more consistent. Return 2, even though it has the same 5-year average annual return as Return 1, has performed horribly over the past 3-years, or even 1-year.
As an investor, you should look carefully at a funds yearly performance to fully appraise its annualized returns.
Compounding or Compound Annual Growth Rate
This metric is what investors or savers can see on their savings or money market accounts.
The Compound Annual Growth Rate, usually expressed as a percentage, represents the cumulative effect of a series of gains or losses on an original amount over a period of time.
To mimic the same example above, to produce a 10% annual compound return over five years means that at the end of the fifth year, the fund's capital has grown to a size equal to what it would be if the original funds at the beginning of each year had grown by exactly 10% by the end of each year.
If you had $1,000 invested, and it grew at a compound rate of 10% annually, it would be worth $1,611 after 5 years. Here is the math:
- Year 1: $1,000 * 10% = $1,100
- Year 2: $1,100 * 10% = $1,210
- Year 3: $1,210 * 10% = $1,331
- Year 4: $1,331 * 10% = $1,464.10
- Year 5: $1,464 * 10% = $1,610.51
However, there does not need to be equal growth to achieve a 10% compound annual return. In the same example, the fund could gain nothing for 4 years, and earn $611 in Year 5, which would equate to the same 5-year compound annual return.
As with any investment, you should do your due diligence to determine the consistency of investment returns and how they are calculated. Just because a fund advertises one return, doesn't mean that is what happened over the last year or two.