Compound Annual Growth Rate vs. Average Annual Return

I’ll be honest with you—writing this makes me feel like Jack Nicholson’s character in the movie “A Few Good Men”. Remember when Nicholson is interviewed 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 is related to the calculation average annual percentage rate?

Well, one of the biggest secrets in the investment industry is that mutual funds, mutual funds and countless other things linked to the interests of the stock market, announce their return figures in a very misleading way.

What is bad? They are not breaking any laws in doing so.

I know…there’s a growing gasp for everyone reading this.

What am I talking about?

Having been in the financial industry since 2000, I’ve noticed that almost all investment companies (mutual funds, ETFs, market indices, variable annuities, closed-end funds, REITs) like to cite their “annual rate of return” as a number that always inflates what the investment returns. for investors. And it bothers me a lot.

2+2 is always 4…except on Wall St.

The problem is not difficult and not flexible in any way, (as the financial industry would have you believe) it comes down to basic math.

The average annual return, as it is referred to in investment books, (commercial, accounting, etc.) is a game that is deliberately designed to confuse your mind about returns by explaining simple mathematical calculations when the only interest that is required is compounding. Compound annual growth (CAGR).

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

Example : Let’s say that Bill puts $100,000 in his savings account at JT Marlin (some of you may find Boiler Room reference) and for 1 year his account grew by 25% but the account returned 25% negative in the second year.

The muppets of the stock market would say that your average return is 0%…and they would be right…in the same way President Clinton swore he never had sex with a woman.

But they are hiding the truth with nonsense – because who cares what your return rate 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 the second year his account is worth $93,750 his annual compound interest (cagr) was -6.25%.

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

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

Welcome to the wonderful world of finance and Wall St speculators.

I found quite a bit on the internet and looked around to see what others were saying CAGR.

Investopedia.com says:

“CAGR is not a real rate of return. It’s an imaginary number that describes how much money would have grown if it had grown at a slower rate. You can think of CAGR as a measure of return.”

To be honest, I am speechless.

Enron’s accountants apparently live on Wall Street and are regulars in the financial news media.

I am requesting to withdraw from Investopedia

Your real return is the return that matters the most. All I can think of is telling Bill (see above) that his account has done almost 0% for the past two years!

Totally insane.

Who cares what I’ve “been up to” in the past two years. If my money stack is shorter than I started with, it’s not a zero-sum game.

That’s the kind of talk that will get you killed anywhere but Wall Street.

So, why does the financial world always refer to return numbers?

I’ll give you a minute to think for yourself.

Are you done?

Because the average annual return always looks better than the actual return.

If you go to moneychimp.com, has a neat tool that allows you to see the numbers as they are. You can play around with different time frames, adjust price movements, and more.

To give you a quick guide, I’ve drawn up a few graphs to show you the difference in the actual return (cagr) versus the annualized return over the past 10, 15, and 20 years.

annual growth rate
10 years average
15 years average
Average age is 20 years

The truth is that most stock market funds are volatile and showing you the average return (the mathematical mean) makes them look attractive. Just look back at the pictures, they really speak for themselves.

What makes average return misleading is that there have been times in the market when the “average return” was right but the actual return on your investment was wrong.

Who cares who 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 the profit. Who cares if the company’s earnings were $1.25 per share but the net profit to shareholders was a penny?

Here’s a great quote from “The Essays of Warren Buffett: Lessons in Corporate America“:

Over the years, Charlie and I have witnessed numerous accounting frauds of staggering proportions. Few of the guilty are punished; many were not challenged at all. It is much safer to steal large sums of money with a pen than small sums of money with a gun.

Find out what Buffet says in this comment, it works here.

Also note that I didn’t look at the inflation returns, which is another great feature of the moneychimp site—you can include the return numbers that have been adjusted for inflation.

Obviously, inflation erodes the returns to real and average figures. No big surprise there.

The saddest thing about all this is, I think most of the people who promote this lie, don’t know that they are doing anything wrong! Calculations that ignore annual growth rates are so intertwined that even advisors, CFPs, financial advisors and other financial professionals churn out numbers without questioning their validity.

I can’t say that they are being dishonest on purpose but I can say that most of them don’t know the truth.

And I don’t know what’s so bad?

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.