CAGR vs Average Return

When looking at mutual funds you should pay close attention to how the company is reporting the returns of its funds. Often, you will see that the return is reported as an average. Unfortunately, an average return really can skew the truth. Just because a fund returned an average of 10% a year doesnít mean that you actually made 10% per year.

To demonstrate how an average return can be misleading we are going to give an example. Letís say an investor invests $10,000 into a fund for 2 years and the ended up with the following returns:

  • Year 1: Gained 50.0%
  • Year 2: Lost 40.0%

With those returns our investor would have ended up with $9000 and his average return would have been 5.0%! What?? How can this investment lose $1000 but have a positive average return? Well an average return is just that: an average. He did get an average of 5.0% gain every year.

CAGR, Compound Annual Growth Rate, is what you really need to look at when comparing returns. You can think of CAGR like the percentage your savings account returns. If your savings account returns 2% a year and you had $10000 invested then you would make $200 that year. Essentially CAGR is the rate an investment would have grown at if it had received the same interest rate every year. In our above example the CAGR was about -5.1%. That is a big difference from the average return of 5.0%.

Hopefully now you have a better understanding of CAGR Vs Average Return.