Understanding Investment Performance: The Advantages of CAGR Over Average Annual Return
When evaluating investment performance, two key measures are frequently used: compound annual growth rate (CAGR) and average annual return (AAR). While they each provide insights regarding an investment's growth, their functions are distinct. Furthermore, the method used to measure volatility, arithmetic vs. geometric standard deviation, has a substantial impact on the interpretation of investment risk and performance. Notably, iQUANT use CAGR and Geometric Standard Deviation to provide a more sophisticated understanding of investment growth and volatility. Let's break down these concepts so we may better understand their significance.
The Limitations of Average Annual Return
The Average Annual Return determines the average percentage return that an investment has achieved over time. While it appears simple, this approach has significant flaws, particularly because it ignores the effects of volatility and the compounding effect. For example, an investment with dramatic changes from year to year may have a good average return but offer a higher risk than the average suggests. This technique may lead investors to underestimate the unpredictability and true risk connected with their investment.
The Advantages of CAGR
CAGR offers a more accurate perspective by measuring the growth rate of an investment as if it had grown at a steady rate on an annually compounded basis. Unlike the average annual return, CAGR accounts for the time value of money, offering a clearer picture of investment performance over time. It effectively smooths out the volatility by illustrating what the annual growth rate would have been, assuming the investment had grown steadily over the period.
Why iQUANT Prefers CAGR
iQUANT prefers CAGR for its ability to provide a realistic and comparable growth rate across different investments and time periods. By capturing the effect of compounding, CAGR allows advisors to make more informed decisions, especially when comparing the performance of diverse investment options over the same duration.
A Real Life Example of CAGR versus AAR
Let's calculate the Compound Annual Growth Rate (CAGR) and the Average Annual Return (AAR) for an original investment of $10,000 with a first-year return of 50% and a second-year return of -50%.
Initial Investment:
Original investment: $10,000
Yearly Returns:
Year 1 Return: 50%
Year 2 Return: -50%
Calculation of Investment Value After Year 2:
End of Year 1: $10,000 * (1 + 50%) = $15,000
End of Year 2: $15,000 * (1 - 50%) = $7,500 (a $2,500 loss from the original investment)
The Compound Annual Growth Rate (CAGR) for the investment over the two years is approximately -13.40%. This contrasts with the Average Annual Return (AAR), which misleadingly suggests a 0% return (despite the $2,500 loss), illustrating how CAGR provides a more accurate reflection of the investment's performance by considering the effects of compounding and volatility over time.
Understanding Standard Deviation: Arithmetic vs. Geometric
When it comes to assessing the risk or volatility associated with an investment, standard deviation is a critical metric. However, the choice between arithmetic and geometric standard deviation can significantly influence the interpretation of results.
Arithmetic Standard Deviation calculates the dispersion of a set of numbers (e.g., annual returns) from their mean. It's straightforward but can be misleading in reflecting investment volatility, especially for long-term investments, because it doesn't account for the compounding effect over time.
Geometric Standard Deviation, on the other hand, is tailored for datasets that undergo exponential growth (like investments). It provides a more accurate measure of dispersion for growth rates, taking into account the compounding effect. This makes it particularly suitable for analyzing investment volatility in conjunction with CAGR.
Why Geometric Standard Deviation?
The advantage of using Geometric Standard Deviation alongside CAGR is its ability to offer a truer representation of the investment's volatility over time, considering the compound growth. It's a more relevant measure for advisors looking to understand the variability of their compounded returns, offering a holistic view of both growth and risk.
Simplifying the Difference
In simple terms, think of Arithmetic Standard Deviation as measuring the average distance of individual yearly returns from the average return, without considering how those returns interplay over time. Geometric Standard Deviation, however, takes the baton from CAGR, continuing the race with a focus on how the investment's return rates vary around the compounded growth path.
Conclusion
While the Average Annual Return can provide a snapshot of past performance, CAGR, especially when analyzed with Geometric Standard Deviation, offers a more comprehensive understanding of both the growth trajectory and the volatility of investments. iQUANT utilize these metrics to equip advisors with the tools needed to make more informed decisions, highlighting the importance of considering both growth and risk in the investment landscape.
Sadly, Separately Managed Accounts (SMAs) and 40’ Act investment products (mutual funds, etc.) usually shape returns around Average Annual Returns instead of Compound Annual Growth Rates (CAGRs). This can make it harder for advisors (and their investors) to accurately see how risky or profitable their investments are, because using average returns doesn't give a proper picture of how investments can grow or change over time