All things being equal, of course, anyone would rather earn 10% than 9%. But when it comes to calculating annualized investment returns, all things are not equal and differences between calculation methods can produce striking dissimilarities over time. In this article, we'll show you annualized returns can be calculated and how these calculations can skew investors' perceptions of their investment returns.

**Tutorial: 20 Investments To Know****A Look at Economic Reality**

Just by noting that there are dissimilarities among methods of calculating annualized returns, we raise an important question: Which option best reflects reality? By reality, we mean economic reality. So which method will determine how much extra cash an investor will actually have in his or her pocket at the end of the period?

Among the alternatives, the geometric average (also known as the "compound average") does the best job of describing investment return reality. To illustrate, imagine that you have an investment that provides the following total returns over a three-year period:

Year 1: 15% Year 2: -10% Year 3: 5% |

Numerically this gives us:

(1.15)*(0.9)*(1.05)^1/3 = 1.0281 |

Does this return reflect reality? To check, we use a simple example in dollar terms:

Beginning of Period Value = $100 Year 1 Return (15%) = $15 Year 1 Ending Value = $115 Year 2 Beginning Value = $115 Year 2 Return (-10%) = -$11.50 Year 2 Ending Value = $103.50 Year 3 Beginning Value = $103.5 Year 3 Return (5%) = $5.18 End of Period Value = $108.67 |

Year 1: $100 + 2.81% = $102.81 Year 2: $102.81 + 2.81% = $105.70 Year 3: $105.7 + 2.81% = $108.67 |

**Disadvantages of the Common Calculation**

The more common method of calculating averages is known as the arithmetic mean, or simple average. For many measurements, the simple average is both accurate and easy to use. If we want to calculate the average daily rainfall for a particular month, a baseball player's batting average, or the average daily balance of your checking account, the simple average is a very appropriate tool. (For related reading, see

*What is the difference between arithmetic and geometric averages?*)

However, when we want to know the average of annual returns that are compounded, the simple average is not accurate. Returning to our earlier example, let's now find the simple average return for our three-year period:

15% + -10% + 5% = 10%10%/3 = 3.33% |

*Overcoming Compounding's Dark Side*.)

Claiming that we earned 3.33% per year compare to 2.81% may not seem like a significant difference. In our three-year example, the difference would overstate our returns by $1.66, or 1.5%. Over 10 years, however, the difference becomes larger: $6.83, or a 5.2% overstatement.

**The Volatility Factor**

The difference between the simple and compound average returns is also impacted by volatility. Let's imagine that we instead have the following returns for our portfolio over three years:

Year 1: 25% Year 2: -25% Year 3: 10% |

*The Uses And Limits Of Volatility*.)

The opposite is also true; if volatility declines, the gap between the simple and compound averages will decrease. And if we earned the exact same return each year for three years - say with two different certificates of deposit - the compound and simple average returns would be identical.

**Compounding and Your Returns**

What is the practical application of something as nebulous as Jensen's inequality? Well, what have your investments' average returns been over the past three years? Do you know how they have been calculated? (For more, see

*Achieving Better Returns In Your Portfolio*.)

Let's consider the example of a marketing piece from an investment manager that illustrates one way in which the differences between simple and compound averages get twisted. In one particular slide, the manager claimed that because his fund offered lower volatility than the S&P 500, investors who chose his fund would end the measurement period with more wealth than if they invested in the index, despite the fact that they would have received the same hypothetical return. The manager even included an impressive graph to help prospective investors visualize the difference in terminal wealth.

Reality check: the two sets of investors may have indeed received the same simple average returns, but so what? They most assuredly did not receive the same compound average return - the economically relevant average.

**Conclusion**

Compound average returns reflect the actual economic reality of an investment decision. Understanding the details of your investment performance measurement is a key piece of personal financial stewardship and will allow you to better assess the skill of your broker, money manager or mutual fund managers.

Which annual investment return would you prefer to have: 9% or 10%? The answer is: It depends on which return really puts more money in your pocket.