Math for Investors — Average Return vs Compound Annual Average Return
Understand the difference between average return and compound annual average return
Wealth building is a doubling game. How long it takes to double your money depends on 3 important factors:
- Rate of Return
- Time Horizon
- Initial Investment Amount
In this article, we will discuss the rate of return.
Rate of Return Definition: The rate of return is expressed as a percentage and represents the growth or decline of an initial investment. As an example, if you invest $10,000 in a business and at the end of year 1, your balance is $11,000, then your rate of return for year 1 is 10%, hence a 10% growth. However, if you invest $10,000 in a business and at the end of year 1 your balance is $9,000, then your investment declined by 10% or a growth of -10%.
When calculating return over a number of years, it is important to distinguish between average return and compound annual average return.
Average Return: Average return is the sum of the annual return divided by the number of years. Table 1 shows the return of an S&P 500 index fund over a 9 years period. By summing the values (column 3) and dividing by 9…