It's all about returns over time. How they grow. Compound. Grow up. Get Bar Mitzvah'd or Quinceanera'd. And then get married, and then triple in size from either pregnancy or depression.
Um...yeah. So the average annual return is a common measure for mutual funds, but calculating the compound annual growth rate (CAGR) is even better. Assuming the investment is really compounding over a certain period of time, you can assess the growth rate from when you made the first investment until the present time.
The reason the CAGR presents a truer picture is that the average annual return does not take into account compounding, so it can overestimate the growth of an investment. The CAGR is an average that calculates the rate at which the investment would have grown if it had compounded at the same rate each year.
The formula for CAGR is:
CAGR = (Ending Value / Beginning Value)1 / n - 1
...where n is the number of periods in months or years.
You invest $2,000 in the We Always Compound fund for five years. Here is the value of your investment at the end of each year:
Year Ending Value
1 $1,500
2 $2,000
3 $6,000
4 $8,000
5 $10,000
You can calculate the CAGR of the investment as:
CAGR = (10,000 / 2,000)1/5 - 1 = .37973 = 37.97%
And yeah, this'll be a lot easier if you use a financial calculator, or Excel.
If you had simply taken an average of the returns from year one (-25%) and two (33%) it would come out to a positive 4%. But actually, the growth was 0%, since you ended up with the same $2,000 you started with.
Related or Semi-related Video
Finance: What is Imputed Interest Rate?1 Views
Finance allah shmoop What is imputed interest rate Imputed guest
at or presumed based on x y and z that's
the foundation of an imputed interest rate and its chief
cheerleader Yep It's the i r s the tax people
those guys you just love to hear from Why Well
because taxes need to be collected Right We have pork
to buy for politicians Come on people Get with it
So we have a zero coupon bond here We bought
for five hundred bucks which comes do or pays off
in ten years for a thousand dollars on lee Remember
Zero coupon bonds don't pay any interest along the way
They just pay a one time end of period amount
which includes interest and principal The irs taxes Bondholders imputed
interest Yes like gains based on whatever interest rate is
imputed by the terms of the deal So in this
case remember that rule of seventy two thing so many
years to doubled about it into seventy two and all
that Yeah So in this case the money takes ten
years to double that's ten into seventy two paying seven
point two percent interest per year Compound it So the
irs would take as an imputed interest Five hundred box
times seven point two which is thirty six dollars of
taxable imputed interest games And they would take that each
year and you'd pay that each year on your taxes
So if you owned this bond and we're living in
a forty percent marginal tax bracket blue state which you
livin bitterly even though you got no cash interest from
this bond will you'd suffer a cash tax hit of
forty percent of thirty six or a bit under fifteen
dollars each year as you went along So that's the
bad news you pay the cash up front The good
news is that when the bond finally came do that
decade later for that grand well you have already paid
the taxes along the way And when taxes are already 00:02:01.504 --> [endTime] paid well we impute you'll be a happier camper
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