Investment Warrior Report Archive Article

Average Annualized vs. Compounded Returns

Many newsletters and financial gurus tout their investment returns or trading history. I am disappointed in the misdirection and hype that many  in the financial industry resort to in order to inflate returns. 

A report of a return should be examined using  "annual COMPOUNDED return" percentages. Misleaders  in the financial trade use a measure called "average annual return" to inflate performance . Here is how  "average annual return" is misleading... 

If you average just a tad more than a 14% return for each year for 5 years you will have doubled your money. Not just 70%  (5 x 14%) but a 100% return on your money. The reason is that there is compounding for each year that your money made 14%. The unscrupulous will use the 100% return, divide it by the 5 years and say that you made an "average annual return" of 20%. If we carry our example out for another 5 years, you now have made a 300% return and if you divide this by the 10 years it seems to be an annual return of 30% per year. However, all of this happens by just using a constant 14% annual compounded return for the 10 years. 

So be aware of hype and people promoting very high average "annual returns". They usually are just using fairly common and average compounded returns for a long period of time, and then taking the "average annual return " by dividing the cumulative return by the number of years . Insist on knowing the "Compounded Annual Return" for a constant and true measure of comparison.



Copyright 2003 Lussenheide Capital Management