How do you measure return on investment?

This sounds like an easy question. But, recently, many advertisements, especially for real estate investments, have begun to tout high rates of return based on compound annual growth rates (CAGR).  What exactly is CAGR and is listing CAGR a deceptive manner of measuring return on investment?

The traditional metric for measuring return is based on the growth of net asset value (NAV). For mutual funds and exchange traded funds (ETF), NAV is calculated as (market value of investments + cash or cash equivalents- liabilities)/total number of shares outstanding. NAV is also an important calculation in non-GAAP friendly business such as real estate or service based business where the intrinsic value of the business is found in goodwill or brand value.

For example, assume you purchase a mutual fund or ETF at $10.00. A year later, your mutual fund or ETF is worth $11.00 a share and 3 years after acquisition date the mutual fund or ETF is worth $14.00. Your 1 year return would 10% and your 3 year return would be 13.3% per annum or 40%.

CAGR is a metric that smooths out the annual return over the time the investment is held. CAGR is calculated by the formula: (value at end of time horizon/value at beginning of time horizon) square root of (1/# of years invested) – 1. More simply, there are CAGR calculators on the web. In plain English, what CAGR is doing is assuming that your investment returns at the same rate for every year you held an investment. Using the same example above, your CAGR is 11.87% which dampens the return in year 2 and 3 by balancing the more modest return in year 1.

Why is CAGR used?

In the real estate investment context, where the exit of a project may be many years away and there may not be a readily available market to sell the investment before exit, CAGR is a valuable tool to measure the opportunity costs versus other investments assuming the same time period is used. The same benefit applies outside the real estate context but CAGR works best for appreciation plays with long-term exits and little to no chance of exit before then. Of course, this means CAGR is limited as a hindsight analytical metric.

For the mutual fund and ETF industry, CAGR can be used as a marketing tool to distort risk analysis. Since CAGR smooths out performance, it removes, viewed purely as a ROI number, the ups and downs in most investments. I would not call the financial services industry using CAGR as a return metric deceptive. Instead, what it is trying to do, for better or worse, is to remove emotions out of our decision making process.

For example, in a market that performs poorly one year and well the next, such as 2008 and 2009, a cursory look at CAGR may give the impression to a potential investor that the mutual fund or ETF has steadily done well and would be a buy. Instead, what CAGR hides, or mitigates the impact of, is that huge negative return in 2008.

As an illustration, let’s assume I purchased a ETF at $10.00 on September 28, 2007. On the one year anniversary of my purchase (i.e. approximately 2 weeks after Lehman Brothers collapsed), that same ETF  traded at $6.50. Today, I sell that ETF at $11.50. This means my CAGR over the course of my investment is 7.24% which is an extremely respectable return.

Here’s the catch though: how many of us would have held on to this fictional ETF in 2008? Studies show that the average investor performs poorly because they cannot rein in their emotions by riding out market lows or leaping in during the highs. The financial services industry is not stupid and knows that the easiest way to market is to post a CAGR figure rather than have the potential investor mull the big negative numbers (by law, mutual funds must disclose 1,3, 5, 10 year and since inspection returns- CAGR is not a required disclosure).

The point is this: CAGR is a useful tool for comparative analysis and for certain types of product as long as the same time period is being used. But,  an over-reliance on CAGR ignores two fundamental realities of day to day investing:

1. The past does not predict the future and substantially relying on past performance as a decision making criteria is dangerous; and
2. CAGR ignores the fact that investors invest with emotions and, in addition to smoothing out performance, it assumes we can all maintain even keel during the period we hold an investment.

The key is not only to look at CAGR in and of itself but how it was derived and whether you would have the emotional control to hold onto the investment during the worst periods.