CAGR vs Average Annual Return
CAGR (compound annual growth rate) is the constant yearly rate that turns a starting value into an ending value, so it reflects compounding. An average annual return is a simple mean of each year’s return and ignores compounding. When returns vary, the average overstates what you actually earned, sometimes by a lot.
At a glance
- Also called
- Geometric vs arithmetic mean return
- CAGR reflects
- Compounding and the actual start-to-end result
- Average reflects
- The typical single-year return, ignoring compounding
- Gap between them
- Grows as returns become more volatile
Why can the average return be positive while you lost money?
Because an arithmetic average treats each year’s percentage as if it applied to the same starting amount, but returns compound: a loss is applied to a smaller or larger balance than the year before. CAGR accounts for that; a simple average doesn’t.
The formulas
Average annual return (arithmetic mean): add up each year’s return and divide by the number of years.
Compound annual growth rate (CAGR):
CAGR = (ending value ÷ starting value)1 / years − 1
CAGR is the single constant yearly rate that would take the starting value to the ending value over the period. It’s a geometric average.
Worked example: +50%, then −50%
You invest $10,000. Year 1 returns +50%; year 2 returns −50%.
| Step | Value |
|---|---|
| Start | $10,000 |
| After year 1 (+50%) | $15,000 |
| After year 2 (−50%) | $7,500 |
| Measure | Result |
|---|---|
| Average annual return | (+50% + −50%) ÷ 2 = 0% |
| CAGR | (7,500 ÷ 10,000)1/2 − 1 ≈ −13.4% |
The average says you broke even. Your account says you lost a quarter of your money. CAGR matches the account.
The rule of thumb: volatility drag
For the same average return, the more returns swing from year to year, the lower the CAGR. A useful approximation is:
CAGR ≈ average return − (variance ÷ 2)
That’s why two funds with the same average return can leave investors with very different amounts: the steadier one compounds to more.
Which one should you use?
| Question | Use |
|---|---|
| How much did my lump sum actually grow per year? | CAGR |
| Comparing two investments over the same period | CAGR |
| Estimating the expected return of a single future year | Arithmetic average (with care) |
| My return with regular deposits and withdrawals | Neither — use money-weighted return |
| A manager’s or fund’s performance with cash flows | Time-weighted return |
What to watch for in marketing
- “Average returns of X% a year” is often an arithmetic mean, which is higher than the CAGR whenever returns vary. Ask for the annualised (compound) figure.
- Check the start and end dates. CAGR is very sensitive to them; starting at a market low flatters the number.
- CAGR hides the path. Two investments with the same CAGR can have very different drawdowns along the way.
To run your own numbers, use our CAGR calculator.
Frequently asked questions
Is CAGR the same as annualised return?
For a single lump sum with no deposits or withdrawals, yes: CAGR is the annualised (geometric) return over the period.
Why is CAGR lower than the average return?
Because returns compound and vary. Whenever yearly returns differ, the geometric average (CAGR) is lower than the arithmetic average. The gap grows with volatility.
Can I use CAGR if I added money over time?
Not accurately. CAGR assumes one starting value and one ending value. With regular contributions, use money-weighted return (IRR/XIRR) for your personal result.
Sources
- CFA Institute: GIPS Standards — standards for calculating and presenting investment performance
- U.S. SEC Investor.gov: Compound interest — regulator explainer and calculator for compounding