Don't be Fooled by Misleading Returns

[Devin James]

Why we don’t like ARR (Average Rate of Return)

It’s easy to skew the numbers.

Here's an example of a positive ARR of 12.5%, but the investment loss is $50.

Year 1

Start Value: $100

End Value: $25

Annual Return: -75%

Year 2

Start Value: $25

End Value: $50

Annual Return: 100%

ARR = 12.5%

Am I missing something here?

Which calculation do you dislike and why?

[Drago Stanimirovic]

Hi Devin,

You’ve identified a key issue with the Average Rate of Return (ARR) — it can be misleading. In your example, the ARR calculation suggests a positive return of 12.5%, but in reality, the investment suffered a loss of $50 over the two years. Here's why this happens:

The ARR is simply the average of the annual returns, without considering the actual capital invested or how much money is lost or gained over time. In your case, the negative 75% return in the first year, and the 100% gain in the second, are averaged to give 12.5%. But, this doesn’t reflect the fact that the initial investment decreased from $100 to $50 over two years.

The flaw with ARR is that it doesn’t take into account compounding or the actual sequence of returns. The correct way to measure the overall performance of the investment would be through a Cumulative Return or Compounded Annual Growth Rate (CAGR). These approaches consider how the capital has grown or shrunk over time, providing a more accurate reflection of actual performance.

For instance, the CAGR in this case would be negative, as it accounts for the overall movement of the investment from $100 to $50 over the two-year period, indicating a loss.

If you'd like further clarification or assistance in understanding other metrics for evaluating investments, feel free to ask! I'm happy to help with any questions you have, including any financing or real estate concerns.

Best,

Drago