Simple Average vs Annual Compounded Rate of Return: Which One Should You Trust?

When it comes to evaluating the performance of your investments, it's important to understand the difference between the different methods of calculating the rate of return (ROR). Two commonly used methods are the Simple Average Rate of Return (SARR) and the Annual Compounded Rate of Return (ACRR). While both methods can give you a sense of how much your investment has grown, they can also be used to mislead you about the true performance of your investment.

SARR, also known as Arithmetic Mean Rate of Return, is calculated by taking the total percentage of growth and dividing it by the number of years invested. The formula for SARR is: (Ending value - Beginning value) / Beginning value / Number of years.

On the other hand, ACRR takes into account the compounding of returns over time and is calculated using the formula:

(Ending value / Beginning value) ^ (1 / Number of years) - 1

Let's take an example of an investment of $10,000 that grows to $150,000 over 20 years.

Using SARR, the rate of return would be calculated as: (150,000 - 10,000) / 10,000 / 20 = 6.25%

Using ACRR, the rate of return would be calculated as:

(150,000 / 10,000) ^ (1/20) - 1 = 9.72%

As you can see, the SARR for the investment is 6.25% which is significantly lower than the ACRR of 9.72%. This discrepancy between the two calculations can be misleading, especially when trying to compare the performance of different investments.

SARR is affected by sporadic or abnormal gains and losses, and it does not take into account compounding, which can be a critical factor in long-term investments. ACRR, on the other hand, is more accurate as it takes into account compounding, which reflects the true growth of an investment over time.

In light of this, it's important to understand the difference between these two methods of calculating the rate of return and to be aware that some financial advisors may use the method that gives their investment the best look. At FS2, we take pride in providing our clients with accurate and reliable information to help them make the best financial decisions. Contact us today to schedule a consultation and ensure that you are fully informed about your investment's rate of return, whether it's SARR or ACRR.