Over the weekend, I was asked the difference between average annual return and compounding (or compound annual growth rate). Really, the question was, if I see a fund with a 10% average annual return, is it the same as putting the same amount in a bank account at 10% interest? I was stumped for a second, but I knew the answer was no. Here is why.

### Average Annual Return

This metric is the industry standard for measuring returns of equity investments. You see it on every mutual fund prospectus. But what does it really mean?

The *Average Annual Return* is a percentage figure used to report a historical return of a given period (most commonly 3-, 5-, 10-year). The most common area using this figure is mutual funds.

The deceptive part of Average Annual Return is how it is calculated. It is simply (Sum of Annual Returns) / (# of Years). For example, to earn a 10% annual return, a fund could perform both of the following ways:

- Return 1: (+10% + +10% + +10% + +15% + +5%) / 5 = 10% Average Annual Return
- Return 2: (40% + +30% + -10% + +5% + -15%) / 5 = 10% Average Annual Return

If you were an investor, you would prefer Return #1, since it is more consistent. Return 2, even though it has the same 5-year average annual return as Return 1, has performed horribly over the past 3-years, or even 1-year.

As an investor, you should look carefully at a funds yearly performance to fully appraise its annualized returns.

### Compounding or Compound Annual Growth Rate

This metric is what investors or savers can see on their savings or money market accounts.

The *Compound Annual Growth Rate***, **usually expressed as a percentage, represents the cumulative effect of a series of gains or losses on an original amount over a period of time.

To mimic the same example above, to produce a 10% annual compound return over five years means that at the end of the fifth year, the fund’s capital has grown to a size equal to what it would be if the original funds at the beginning of each year had grown by exactly 10% by the end of each year.

If you had $1,000 invested, and it grew at a compound rate of 10% annually, it would be worth $1,611 after 5 years. Here is the math:

- Year 1: $1,000 * 10% = $1,100
- Year 2: $1,100 * 10% = $1,210
- Year 3: $1,210 * 10% = $1,331
- Year 4: $1,331 * 10% = $1,464.10
- Year 5: $1,464 * 10% = $1,610.51

However, there does not need to be equal growth to achieve a 10% compound annual return. In the same example, the fund could gain nothing for 4 years, and earn $611 in Year 5, which would equate to the same 5-year compound annual return.

### Bottom Line

As with any investment, you should do your due diligence to determine the consistency of investment returns and how they are calculated. Just because a fund advertises one return, doesn’t mean that is what happened over the last year or two.

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Moneycone says

You’ve explained the difference beautifully Robert! Always look at year to year return in comparison to S&P to see how consistent a fund is.