CAGR vs average return
Averaging a series of yearly returns gives a number that is almost always too high, and sometimes wildly so. What CAGR measures instead, and why the gap grows with volatility.
Work out a CAGRThe example that makes the point
An investment returns +50% one year and −50% the next. The average of those two returns is zero, so it broke even. It did not: ₹100 became ₹150 and then ₹75. You are down a quarter, and the compound annual growth rate is −13.4% a year.
This is not a trick with unusual numbers. It happens whenever returns vary, in the same direction every time, and the more they vary the larger the gap. The simple average of a return series is essentially always higher than the rate that actually connects where you started to where you ended.
What each one measures
The average return answers 'what was a typical year like'. CAGR answers 'what constant rate would have got me from the start value to the end value'. Only the second one describes what happened to your money, which is why it is the one worth quoting.
| Series | Year 1 | Year 2 | ₹100 becomes | CAGR |
|---|---|---|---|---|
| Steady | +10% | +10% | 121.00 | 10.0% |
| Volatile | +40% | −20% | 112.00 | 5.8% |
| Very volatile | +70% | −50% | 85.00 | −7.8% |
Where you will meet the difference
Fund fact sheets are generally careful about this and quote annualised returns, which are CAGR. Marketing material, forum posts and back-of-envelope comparisons frequently are not, and a fund advertised on the average of its yearly returns is being flattered by its own volatility.
The check is easy: if you are shown a list of yearly returns and a headline figure, add up the yearly ones and divide. If the headline matches, it is an average and it overstates what you would have made.
What CAGR does not tell you either
It hides the path completely. Two investments with the same CAGR can have been utterly different to hold - one grew smoothly, the other halved in the middle and you would have sold. CAGR is silent about that, and about whether you could have stayed invested through it.
It is also extremely sensitive to the two dates. A CAGR measured from a market bottom to a market peak is a statement about the dates, not about the investment, and it is worth asking why a particular period was chosen whenever one is quoted at you.