What is the difference between average annual return and cumulative return?

Returns can be presented on a cumulative basis or as an annual compound rate. It is critical that investors understand the difference between these two methods of reporting.

Cumulative Returns

Cumulative returns express the total percentage increase in the value of an investment from the time it was purchased.

Example: You purchased XYZ shares 10 years ago for $10,000. Today XYZ shares are worth $20,000. To calculate the cumulative investment return, you would first take the current value of your XYZ shares ($20,000) and subtract the price at which you originally purchased the shares ($10,000). This would give you your total dollar gain ($10,000). Next divide your total dollar gain by the total cost of the shares ($10,000 initial investment/ $10,000 gain = 1, or as expressed as a percent: 100%). In this example, over a ten year period you have doubled your investment and your cumulative return is 100%.

Brokerage account statements generally report a cumulative return in the gain/loss section of their statements.

Annual Compound Returns

Annual compound returns express the rate of return which, if compounded over the years covered by the performance history, would yield the cumulative gain or loss actually achieved during that period.

A simple way to think about annual compound returns is to consider its use in banking. If you were to go into a bank and ask the teller what their savings accounts were yielding, you would be given an annual compound rate (or something very similar).

Revisiting our previous example: In order to achieve a 100% cumulative rate of return over a ten year period, what annual compound rate of return must your XYZ shares achieve?

The answer is 7.2%. If your XYZ shares grow at a 7.2% annual compound rate for 10 years, you will have doubled your investment and achieved a 100% cumulative rate of return.

The math involved in this calculation is complex. If you would like dive into the details you can read more here:  Calculate a Compound Annual Rate of Return

Why Should I Care About Annualizing Returns?

Returns expressed as an annual compound rate are useful because they give investors the opportunity to make direct comparisons. Annual compound rates of return are often quoted on a 1,3,5, and 10 year basis. This gives investors the ability to easily compare how different investments performed during the same periods of time.

To highlight the challenges involved with comparing two investment’s cumulative returns, consider the following:

Question: Did an investment with a five-year cumulative return of 93% do better or worse than one with a ten-year cumulative return of 271%?

Answer: Their annual compound rates of return were identical, 14%.

Conclusion

When an advisor or fund manager provides you with a performance figure touting high returns, it is critical that you understand whether you are being quoted a cumulative rate of return or an annual compound rate. As you have hopefully learned by reading this article, the two methods of reporting express very different things.

The information in this post was compiled by S. Zachary Fineberg, Managing Member of Fineberg Wealth Management, LLC, a registered investment advisor. If you would like to schedule a consultation to discuss how Fineberg Wealth Management can help you reach your long-term financial goals, please contact us by email or call (734) 230-7900.

Investors judge the performance of an investment by looking at how much it brings in returns. They may employ multiple methods of calculating investment returns, the main two methods being cumulative returns and average annual returns. Both of these measurements have their benefits, and it is important to know the difference between them when you are making investment decisions.

Measuring Cumulative Return

Cumulative return measures the entire return of an investment relative to the principal amount invested over a specified amount of time. The amount of time may be months, one year or many years; the measurement term depends completely on the party making the measurement. To calculate cumulative return, subtract the original price of the investment from the current price and divide that difference by the original price. Express the answer as a percentage. For instance, if an investor puts $1,000 into a particular stock and the total value of her stock appreciates to $2,500 over a 10-year period, her investment has undergone a 150-percent cumulative return.

Measuring Average Annual Return

Also called the internal rate of return, the average annual return measures average return of an investment every year over a certain number of years instead of the total return amount at the end of that term. Like the cumulative return calculation, this is also expressed as a percentage. To make this calculation, subtract the value of an investment at the end of a particular year from the value of that investment at the end of the previous year and divide that difference by the value of the investment at the end of the year in question. Do this for every year of the term for which you wish to measure the average annual return. Express each year's return as a percentage. Average all of these percentages together to find the average annual return.

Avoiding Mistakes

A common mistake inexperienced investors may make is to assume that they can divide the cumulative return by the amount of years in the term measured and get the average annual return. This, however, will not yield a correct measurement of the average annual return. For instance, an investment that results in an average annual return of 20 percent is going to yield a cumulative return of much higher than 200 percent after 10 years.

Choosing a Method

As both the cumulative return method and the average annual return method are both common, you may use either one to express the return on a particular investment. Cumulative return is the method to use if you are making projections based on an intent to sell an investment at a specific point, while average annual return is the method to use if you are trying to analyze the long-term health of a particular investment.

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