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.

Time	A Investment	Amount		B Investment	Amount
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.