When it comes to investment returns, based on some earlier articles, you may be thinking that it’s no big deal. An investment (hopefully) grows X% a year, and that’s that.

And that’s true, but only to a point. There is more confusion about how to measure (and assess) investment returns than you might think. In the previous article, we discussed the basics of how investments grow through market return and ongoing contributions, compounding over the long term. But how do you evaluate the historical return of a specific investment (stock, bond, or mutual fund)?

You may be familiar with Dave Ramsey, and perhaps you’ve even taken his Financial Peace University (FPU) class. There was a big “dust-up” last year online when Dave claimed that retirees could withdraw 8 percent a year from their savings for their lifetime. He based that on some simple math: The stock markets earn 12% annually,[1] and inflation is 4%; therefore, you can spend the difference. This equation implies a 12% annual average return, but the problem is that nobody receives that average yearly.

Dave’s math works perfectly if we all receive precisely 12% nominal (not inflation-adjusted) returns each year, with exactly 4% inflation each year. But if you’ve been investing for a few years, or bought a car or groceries, you know that’s not how the real world works—returns and inflation are not constants.

Things become significantly more complicated once we factor the variability of market returns (a/k/a volatility) into the equation. Some years, returns are high; some years, they are low; and some years, they are negative.

The confusion arises from the fact that different methods of measuring investment returns are used. The most common is what is called the arithmetic (average) return versus a more accurate measure known as the geometric (compound) return.

Arithmetic returns don’t always reflect reality. If you’ve ever looked at an investment fund’s performance, you’ve probably seen something like this:
“Average annual return = 8%.” Seems straightforward, right? You might assume your investment will grow by 8% every year like clockwork. But that’s not how it works, and understanding why can help you avoid costly mistakes.

Let’s break down the different ways returns are calculated, why arithmetic average returns can be misleading, and what you should pay attention to instead.

The arithmetic average is just the simple average of a set of returns. If an investment returned +10%, –5%, and +15% over three years, the arithmetic average is:

Arithmetic Average Return = (R₁ + R₂ + ⋯ + Rₙ) ÷ n

Where:
R = return for a specific year (1, 2, 3, etc.)
n = total number of years

For example:

(10% + (–5%) + 15%) ÷ 3

= 20% ÷ 3 = 6.67%

= 6.67%

At first glance, it seems like you earned an average of 6.67% per year. But that’s not what actually happened. To understand, we have to look at the geometric return.

The geometric return (also called the compound annual growth rate, or CAGR) tells you what your investment actually grew to over time. It takes compounding into account, the key concept we discussed in the previous article.

Using the same example:

• Year 1: +10% ⇒ 1.10

• Year 2: -5% ⇒ 1.10 × (1.0 – .05) = 1.045

• Year 3: +15% ⇒ 1.045 × (1.0 + .15) = 1.20175

So $1 became $1.20 over 3 years. And the geometric average return is:

(1 + 0.10) × (1 – 0.05) × (1 + 0.15)

= 1.10 × 0.95 × 1.15

= 1.20175

CAGR = (1.20175)^1/3 – 1 ≈ 6.32%

Notice how it’s lower than the arithmetic average, though not by a lot (6.32% vs. 6.67%). That’s always the case when there’s any volatility; the geometric return is more realistic. However, this can be a more significant factor over longer periods. For example, according to the Motley Fool, “the average annual return for the S&P 500 from 1928 through 2024 has been 8%. But that overstates the compound annual growth rate of the index, which has been just 6.2%.”

Compound annual growth is a more accurate indication of how much an investment will grow over time. If we factor in inflation (real return), we would arrive at a much lower number (~3.2%).

Geometric (compound) returns are better than arithmetic averages because arithmetic returns ignore compounding (they treat each year’s return as if it happened singularly) and they don’t reflect volatility (a 50% gain followed by a 50% loss gives you a 0% arithmetic return, but your portfolio is actually down 25%!

So, use arithmetic returns for quick, easy math, but use geometric returns for real planning.

Had enough of this? But wait, there’s one more measure to know: dollar-weighted return, or internal rate of return (IRR). This takes into account the timing and size of your contributions or withdrawals.

Example:

• You invest $1,000 at the start of Year 1.

• In Year 2, you invest another $10,000.

• The investment performs poorly in Year 1 and significantly better in Year 2.

Your personal return will be better than the fund’s published return because most of your money was invested during the good year. The dollar-weighted return captures that; it reflects your actual experience, not just the fund’s performance.

For that reason, if someone says, “I’m earning what the fund earns,” they may not be 100% right. Your actual return depends on when you invest and the amount you invest. If you buy high and sell low, you can underperform the fund’s return by a wide margin.

For reflection: Understanding how investment returns really work helps you steward your resources more faithfully, without falling for oversimplified or misleading financial claims or advice. Because we live in a fallen world, we have to be careful, not cynical, but wise. And when it comes to investing, be wise about how performance and returns are measured and reported. They may not be “untrue,” but they may not be the “whole truth” either.

Verse: “A false witness will not go unpunished, and he who breathes out lies will not escape” (Proverbs 19:5, ESV).

Note:

[1] Dave's 12% figure may be tied to a specific mutual fund that he invests in, which has returned an average of 11.9% over the last 20 years or so. That’s an exceptional return—higher than the market as a whole, so good for him (and for the mutual fund he invests in). Still, as we’ll see, it may not be a 100 percent accurate indicator of how his investment performed.