One of the common statistics used to size up a potential investment is AAGR (Average Annual Growth Rate). If you have ever bought a mutual fund I’m sure you’re familiar with the term “average annual return.” And if you’re like most investors, you’ve used this statistic as one of your primary selection factors.
Have you ever bought a fund with a great “average annual return” and wondered how come your money is not growing at the fantastic rate you expected based on the numbers? You’re several years into the the investment and your account has not grown at all…what happened?
It can be summed up by the phrase, “Lies, damned lies and statistics?”
According to Wikipedia the phrase is used to describe ” the persuasive power of numbers, particularly the use of statistics to bolster weak arguments, and the tendency of people to disparage statistics that do not support their positions.” In other words, you can get numbers to say anything you want.
Let’s take an example.
Someone approaches you with a great investment idea claiming the “average annual return” for the last 2 years is 25%. You think to yourself, “Wow, that sounds great. At that return using the rule of 72 I”ll double my money in 3 years!” You decide to invest $50,000.
Now it’s two years later and low and behold the investment performed as advertised, 25% average annual return. You’re ecstatic…that is until you look at your statement.
Let’s look at your actual return;
Year 1: Plus 100%…$50,000 becomes $100,000
Year 2: Minus 50%…$100,000 becomes $50,000
2 Year Average: 25% (100%-50%) / 2…NO RETURN!
The issue with focusing on average annual investment returns is that it’s only the simple average and does nothing to tell you what your REAL RETURNS will be. If you want a true picture of what your actual returns will be you need to focus on your Compound Annual Growth Rate (CAGR). CAGR is the year-over-year growth rate of an investment over a specified period of time.
Volatile investments (such as mutual funds) are frequently stated in terms of the simple average, rather than the CAGR that you actually get (because the CAGR is smaller). In our example above the CAGR is zero. Knowing this from the beginning would have allowed you to make a more informed decision.
p.s. The CAGR for the stock market over the last decade was .31%! If you have been invested in stocks over the last 10 years your REAL RETURN is basically zero…