The investment industry is fraught with technical terms, acronyms and jargon. For most investors, much is of little use and can overcomplicate or confuse discussions. This series of short notes touches on some commonly used - and commonly misunderstood – issues to help investors gain a greater understanding of the investment world, and bust through the investment jargon.
Return is the ultimate concern for any investor, and can be stated in many different ways. Some ways are more useful than others depending on the context. Sometimes results are just stated as ‘return’, but it is important for investors to understand what type of return is being presented. This note illustrates the difference between some common return terms used in presentations1.
Annualised return is perhaps one of the most commonly presented. Some have coined it ‘the return an investor eats’. In essence, it gives the return would have received each year over an investment horizon to have gotten from the starting value to the ending value. It also sometimes appears stated as the compound annual growth rate (CAGR) or geometric mean return. An interesting phenomenon with this type of return is that it is affected by how volatile an investing journey is2. Higher volatility leads to lower annualised return, ceteris paribus.
Another way returns are often presented is in cumulative terms, also stated as holding period return. Cumulative returns simply state the return needed over the entire period to get from the starting value to the ending value.
The final return type considered in this note is a simple arithmetic average return, or arithmetic mean. This is what many might think about when talking about ‘averages’ – taking the simple average of all annual returns in a sample. It has a usefulness, but it differs from annualised return defined above and ignores the impact of volatility and compounding. The arithmetic average return will always be higher than the annualised return.
Consider the (a little extreme, but illustrative) example below. It compares the outcome over a 6 year time period of two scenarios. Both scenarios have the same arithmetic average return of 5%. However, the higher volatility of Scenario 1 has resulted in a worse outcome, achieving just 4.2% annualised return (27.8% cumulative) vs 4.8% (32.7% cumulative) for Scenario 2.
As an investor it is useful to know the context in which the data are presented to you. Stay alert!
1 This article does not cover the concepts of money-weighted and time-weighted returns. A very important topic which deserves its own note!
2 For more information on the term ‘volatility’ see https://albionstrategic.com/news-and-blog/jargon-busting-volatility