Introduction:
In an earlier post, we discussed the Dividend Irrelevance Theory. Can the same be said about average market returns? Perhaps “irrelevant” is a bit too strong a term in reference to average returns, but they can certainly be a bit misleading. As investors seek more accurate and comprehensive measures, the Compound Annual Growth Rate (CAGR) emerges as a superior alternative. In this exploration, we dissect the limitations of (arithmetic) average returns, highlight the nuanced benefits of CAGR, and illustrate why it offers a clearer lens for assessing investment success.
Hypothetical Examples
Consider the Following Extreme Scenarios:
Mary and John both have a portfolio of $100,000 at the age of 35, and they never add to it for the next 30 years. Both achieve an average return of 15% on their investment, which by all accounts is a phenomenal return.
Mary consistently earns a 15% return every year (averaging 15%) over 30 years. At the age of 65, Mary’s portfolio has grown to over $6.6 million.
John also averages a 15% return, but his returns are more volatile. In the first year, John sees an 80% return, followed by a -50% return in the second year (averaging 15%). He continues this pattern of +80% followed by -50% for the entire 30 years. Surprisingly, after 30 years, John ends up with under $21,000. That’s correct! Even though John was averaging 15%, he was losing 10% every two years.
While these examples are extreme, the more volatile the returns, the further the arithmetic average deviates from the actual compound rate. For instance, two years of 15% returns will result in a 32.25% increase in a portfolio. In contrast, a 16% return followed by a 14% return will result in a 32.24% increase, and a 17% return followed by a 13% return will result in a 32.21% increase. The difference grows larger as returns become more volatile.
Indeed, as evident in these historical returns from MoneyChimp, the average market return between 1871 and 2022 was 10.81%, while the Compound Annual Growth Rate (CAGR) lagged behind at 9.16%.
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The Limitations of Average Returns and vulnerability to Outliers:
A. Distorted Metrics:
The influence of outliers on average market returns can significantly distort the true picture of an investment’s performance. While the arithmetic average calculates the mean return by summing all values and dividing by the number of observations, it is highly sensitive to extreme values. Exceptionally high or low returns, often caused by unforeseen events or market anomalies, can skew the average, providing a misleading representation of the overall market performance. Investors relying solely on the arithmetic average may find their expectations misaligned with the actual investment landscape, as outliers can create a distorted perception of the average return’s reliability.
B. Short-Term Market Impact:
Average returns are particularly susceptible to the impact of short-term market fluctuations. In a dynamic market environment, where prices can be influenced by various factors, including economic news, geopolitical events, or changes in investor sentiment, relying solely on the average return may lead to erroneous conclusions. Short-term market volatility can introduce noise into the calculation of average returns, making it challenging to discern the underlying trends and causing investors to potentially misinterpret the true nature of an investment’s performance. Acknowledging the short-term market impact is crucial for a more nuanced evaluation of investment returns.
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C. Volatility Impact:
Investments subject to market fluctuations often exhibit a degree of volatility, and this volatility can significantly impact the reliability of average returns as a performance metric. When calculating the arithmetic average, the inconsistent growth patterns resulting from market volatility may not be adequately captured. This inconsistency can undermine the usefulness of the average return as an indicator of overall investment success. Investors need to recognize that relying solely on average returns may overlook the inherent risk and variability associated with certain investments, leading to an incomplete assessment of their potential returns. Incorporating measures that account for volatility, such as standard deviation or other risk-adjusted metrics, can provide a more comprehensive understanding of investment performance.
The Precision of CAGR:
A. Defining CAGR:
True Growth Assessment:
Compound Annual Growth Rate (CAGR) stands out as a valuable metric in assessing investment performance due to its ability to provide a true and comprehensive understanding of growth over a specified period. Unlike simple average returns, which might be distorted by outliers or short-term fluctuations, CAGR considers the compounding effects on investment returns. By calculating the geometric mean over time, CAGR encapsulates the consistent annual growth required for an investment to reach its final value. This approach ensures a more accurate representation of an investment’s true growth trajectory, offering investors a reliable metric for evaluating long-term performance.
Stability Amidst Volatility:
One of the significant strengths of CAGR lies in its capacity to offer stability amidst market volatility. Short-term fluctuations, typical in financial markets, can introduce noise and uncertainty into performance metrics. CAGR, however, effectively smooths out these fluctuations, focusing on the compounded growth rate over the entire investment horizon. This smoothing effect provides investors with a more stable and reliable measure of performance, reducing the impact of temporary market disruptions on the overall assessment. As a result, CAGR becomes particularly beneficial for those seeking a consistent and dependable metric to gauge investment success, especially when faced with the inherent volatility of financial markets.
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Practical Implications:
A. Informed Decision-Making:
Accuracy in Comparisons:
The use of Compound Annual Growth Rate (CAGR) in investment analysis enhances the accuracy of comparisons between different investment options. Given its ability to factor in compounding effects and provide a true growth assessment over time, CAGR offers investors a reliable metric for evaluating the relative performance of various investment choices. Informed decision-making becomes more achievable as CAGR minimizes the distortions that may arise from short-term fluctuations or outliers in other performance metrics. As investors seek to make sound choices in a complex financial landscape, relying on CAGR can contribute to a more precise understanding of the growth potential associated with different investment opportunities.
Long-Term Alignment:
CAGR aligns seamlessly with a long-term investment perspective, capturing the essence of an investment’s true growth potential over an extended period. This alignment is crucial for investors with a strategic focus on accumulating wealth over time. By emphasizing the compounded annual growth, CAGR offers a metric that resonates with the goals of long-term investors, providing a reliable measure to assess the sustainable growth of their portfolios. The long-term alignment of CAGR reinforces its utility as a tool for making well-informed investment decisions that stand the test of time.
B. Managing Expectations:
Realistic Assessment:
CAGR plays a pivotal role in fostering a realistic and stable assessment of investment performance. Investors can rely on CAGR to gain insights into the actual growth achieved by an investment over a specified period, minimizing the influence of short-term market noise. This realistic assessment is invaluable for setting expectations based on genuine performance metrics, allowing investors to form a more accurate understanding of their investments’ capabilities. By avoiding the pitfalls of relying solely on average returns, investors can make more informed decisions and better navigate the complex landscape of financial markets.
Conclusion:
As investors seek more nuanced and accurate metrics for evaluating investment success, average market returns are increasingly being scrutinized for their limitations. Enter the Compound Annual Growth Rate (CAGR), a measure that factors in compounding effects and provides a stable metric for assessing long-term performance. Embracing CAGR as a key evaluation tool empowers investors to make more informed decisions and gain a clearer understanding of true investment success in the ever-evolving financial landscape.
