Average Annual Return vs. Compound Annual Growth Rate
Beware of operators inflating their returns by promoting high “average annual returns.”
In reality, the performance of the underlying investment doesn’t change. It’s simply presented in a more favorable light by utilizing the power of compound interest across different investment periods.
By manipulating hold periods, an investment with the same yield can have average annual returns that vary widely.
For a concrete example, let’s look at how returns can be inflated by considering an investment yielding 9%, compounded quarterly, across various hold times.
$100,000 Yielding 9% - Compounded Quarterly
| Investment Period | Future Value | Compound Interest | Interest per Year | Average Annual Return | CAGR |
|---|---|---|---|---|---|
| 1 year | $109,308 | $9,308 | $9,308 | 9.31% | 9.31% |
| 5 years | $156,051 | $56,051 | $11,210 | 11.21% | 9.31% |
| 10 years | $243,519 | $143,519 | $14,352 | 14.35% | 9.31% |
| 15 years | $380,013 | $280,013 | $18,668 | 18.67% | 9.31% |
| 20 years | $593,015 | $493,015 | $24,651 | 24.65% | 9.31% |
As shown above, investment periods can significantly alter the average annual return.
But the operator’s performance didn’t change.
It’s still 9%.
Compound interest did the work.
Compound Annual Growth Rate
The compound annual growth rate (CAGR) is a more accurate measure of calculating returns over time.
It provides an accurate measurement of return that can’t be manipulated across various investment periods.
At Meridian, we use the CAGR when explaining compounding with partners.
It’s the fair way to present returns to partners, and the right thing to do.