When most people look at the return on investments, most of the time the returns are listed in terms of Average Rate of Return (ROR).
When trying to decide what investments are best to help you grow your wealth, you should be using the Compound Annual Growth Rate (CAGR) as the measuring metric.
This is very important to understand because many times ROR will be used incorrectly by advisors or even in a misleading manner (intentionally or not).
While this seems elementary, there is a big difference between calculating the average ROR vs. the CAGR.
The average ROR is the gain or loss on an investment over a specified time expressed as a percentage.
The CAGR is the mean annual growth rate of an investment over a specified time longer than one year.
The best way to explain the difference is to use an example.
If you start with $100,000 and in year one you generate a 25% return, you have $125,000. If you lose 25% in year two, what do you have? $100,000? Nope.
If you averaged the ROR, you’d get ZERO (25% – 25% = 0%).
However, in real life, you only realize the CAGR, NOT the average annual ROR many brokers and fund managers claim. The CAGR for each of the two years is -3.175% (NOT ZERO).
Look at the next set of numbers where the average ROR over 10 years is the same 7% for both investments, but the total value again is different.
$983,576 = Average ROR total
$968,043 = Random rate of return total using the CAGR to tally the numbers
Difference = $15,533
The point with this simple but important example is to make sure readers know the difference so they can make sure they are looking at the CAGR when reviewing different investment options, NOT the average ROR. Only when you use CAGR can you truly compare different investments and make an informed decision as to which one is best.
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The information provided is intended to be educational in nature and is not intended to be a recommendation for any specific investment product, insurance product, strategy, plan feature or other purposes. The above example is for illustrative purposes only and does not take into account your particular investment objectives, financial situation or needs and may not be suitable for all investors. It is not intended to project the performance of any specific investment and is not a solicitation or recommendation of any investment strategy. Click here to read full disclosure.