A Closer Look: Arithmetic vs. Compounded Returns
Maximize Compound Annual Growth Rate
Unveiling the Truth About Investment Returns: Aerage vs Compound
When it comes to investing, it's essential to look beyond the surface and understand the true impact of market conditions on your returns. Let's dive into a story of two investments, A and B, and unravel the complexities of their performance over time.
Start
$100,000
$100,000
Year 1
50%
$150,000
20%
$120,000
Year 2
-30%
$105,000
5%
$126,000
Year 3
50%
$157,500
10%
$138,600
Year 4
-30%
$110,250
5%
$145,530
Year 5
20%
$132,300
10%
$160,083
Total
60%
50%
Annual average
12.0%
10.0%
CAGR
5.8%
9.9%
Standard deviation
40.2%
6.1%
The Initial Comparison
In the first year, Investment A seemingly outshines Investment B by a significant margin. At first glance, A appears to be the clear winner based on its impressive performance. But as seasoned investors know, the market can be unpredictable.
The Impact of Market Conditions
In the second year, the tables turn. Market conditions take a downturn, and while Investment A suffers a substantial loss of -30%, the more conservative Investment B manages to hold its ground with a modest return of around 5%. This shift in market dynamics sets the stage for a deeper analysis.
A Closer Look: Arithmetic vs. Compounded Returns
As we extend our analysis over a five-year period, a more nuanced picture emerges. While Investment A may boast a higher arithmetic average return of 12% per annum compared to B's 10%, the story changes when we consider compounded returns.
Unveiling the Compounded Truth
Despite A's higher arithmetic average return, Investment B proves to be the real winner in terms of compounded annualized return. With a compounded annualized return of 9.9% compared to A's 5.8%, B demonstrates superior performance over the long term.
The Importance of Risk Management
This tale underscores the significance of risk management in investment strategy. While chasing high returns may seem enticing, managing risk effectively is crucial to minimizing losses and maximizing compounded returns in the long run.
Realistic Expectations in Investing
In the world of investing, consistent and substantial gains are rare. Even professional investors face challenges in achieving remarkable returns consistently. For the average investor, the odds are even more daunting. It's crucial to approach investing with realistic expectations and a sound risk management strategy.
Moving Forward: Making Informed Decisions
Armed with this knowledge, investors can make more informed decisions about their investment strategies. By prioritizing risk management and focusing on long-term compounded returns, investors can navigate the complexities of the market with confidence.
Last updated