What’s the difference between Compound Annual Growth Rate (CAGR) and annualized return?
Some investors rely on compounding to help them have financial independence, but many end up confusing CAGR for annualized average return. When financial advisors quote annualized return, even more confusion can occur. Being confused by your advisor when trusting them with your finances is something that we never want you to feel.
Compound Annual Growth Rate (CAGR)
Let me show you a scenario to help you better understand CAGR. You have $10,000. This year, that grows 100%, which leaves you with $20,000 now. Now, let’s say that next year your investment happens to fall 50%, taking you back to the original $10,000 that you had the previous year.
Over those two years, your annualized gain would be zero, meaning that you did not make or lose any money. That zero-percent is what we call the Compound Annual Growth Rate.
Some advisors may try to tell you that your return would be 25%, but that number would actually be your average annual return, making it misleading. If you had actually earned 25% for your investment, you would’ve made more than what you started with, which you didn’t.
Average Annual Return
In the previous scenario, you have 0% gain if you use the CAGR calculation - but a 25% gain if you use the average annual return calculation. This is because average annual return does not account for compounding. Instead, it takes each year’s growth rate, adds them all together, and then will divide by the total number of years.
So, How Are CAGR and Annualized Average Return Used?
It is easier to determine Annualized Average Return, which means that it’s used when you want to quickly see how an investment may be performing.
Get in Touch With an Experienced Wealth Management Firm
It’s important for your wealth management advisor to give you the number that makes the most sense for your scenario. Our advisors at Quraishi Law and Wealth Management will work with you and explain the process based on your situation. We want to ensure that you understand and aren’t misled by something that you may not understand. Contact us online today or give us a call at 870-275-4304.
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