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1906, Mark Twain: "Figures often beguile me. There's 3 kinds of lies: lies, damn lies and statistics."
Well, Mr. Twain, here's today's perfect example of that.
Which number will a mutual fund report 0%/year or +25%/year?
Follow this example - it's not that complicated.
You put $100 in a fund, a year later it has dropped 50% to $50, next year it rises 100% to $100. You're back where you started two years later.
Average Annual Performance
(year 1 + year 2)/ 2 years
(-50% + 100%)/2 = 25%/year (Uh oh.)
Annualized Compound Performance
(total percentage change over 2 years)/2years
= (0/100)/2 = 0%/2 = 0%/year
Note: We've used a simple, brief example to illustrate the concept - contact us if you want to explore the numbers in more depth. Annualized compound growth rate is also often referred to as "CAGR".
The only reason to calculate average annual performance is to use it to calculate standard deviation so you can understand the fund's volatility.
The average annual performance calculation skews results higher and at same time rewards volatility.
The standard deviation of these numbers are: 106.6%. Of course, two years is not much data to calculate Std Dev.
The example above should be reported while noting the 2-year period in question:
"0%/year CAGR with Std Dev of 107%" -
Instead the mutual fund company likely reported 25%/year average annual return.
Many advisors do not understand and/or are not aware of this, joining most of the general public.
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