Comparing returns of potential investments can be difficult. Any investment group is going to put the best possible face on their products, and the choice of the type of return that is quoted can be insightful. It is important to understand the various methods of expressing returns so you can be sure that you are comparing apples to apples, and also to spot the potential downsides that are being glossed over.
Without going into detailed math, which can be covered on websites describing the technical details for those who are interested, here are several of the most common methods by which investment return is expressed:.
- Rate of Return – The change in the beginning value of your investment, expressed as a percentage of the beginning value. If you invested $1,000 and over some period of time ended up with $1,100, your rate of return is $100/$1000, or 10%. (Okay, maybe we will use just a little math.)
Rates of return can be misleading unless the timeframes are known to be the same.
- Average Rate of Return – An average of all of the rates of return for a given year. This can be quite misleading, because it does not account for negative returns.
For example, you invest $100 and in one year, it doubles to $200. Your return was ($200 – $100)/$100 or 100% for that year. Next year you lose half of the value and you are back where you started at $100. Your return is ($100 – $200)/$200 or -50% for that year.
The average rate of return would be (100% – 50%)/2, or 25%. Your real rate of return is zero – you started with $100 and ended with $100.
- Annualized Rate of Return – This can be used to handle variations of return within a period, like the average rate example above. It is the annual rate of a fixed investment that would have given the same return over the same period as the investment you are measuring.
Take the rate of return example above. If that example were measured at the one-year mark, the rate of return and annualized rate of return would be the same (10%).
However, if that example were over a two-year timeframe, a 10% annualized rate of return would yield $1,210 ($1,000 plus $100 in interest in the first year plus $110 interest on the $1,100 balance in the second year). If you invested $1000 and ended up with $1100 in two years instead of one, your annualized rate of return would be just under 4.9%.
Both of the above examples gave a 10% rate of return, but one was clearly superior in reality.
Because the annualized rate of return takes compounding into account, it is often called the Compound Annual Growth Rate (CAGR). Using this method, different types of investments can be compared directly as long as the time scales are the same. It is easy to compare types of investment this way – for example, how a particular stock does against similar stocks in a sector, or how it compares to a standard market index.
CAGR is an improved method, but it still has blind spots. By definition, CAGR smooths out variations in return over the period of time. Therefore, it does not measure volatility – a reflection of the amount of risk the investment poses. A clever fund could tout a high value of CAGR over a 5- or 10-year period by choosing a time frame corresponding to peaks and giving an allegedly superior result to a more steady investment. A way to get around this is to use a risk-adjusted CAGR, which uses the standard deviation in the price as a factor.
Also, keep in mind that the above methods compare values of an initial investment without any extra deposits or withdrawals. With inflows and outflows, you will need a different form of calculation such as Fixed Rate Equivalent, Internal Rate of Return, or Time Weighted Averages.
Every method of evaluating investment returns has good points and bad points – but overall, the CAGR method is one of the best at comparing investments over the same time frame so you can make the best investment choice for your needs.