ROI vs. CAGR: which return number should you trust?

“This investment returned 80%.” “This investment grew 12% a year.” Both sentences can describe exactly the same result. The first is return on investment (ROI); the second is the compound annual growth rate (CAGR). Knowing which one you are looking at — and which one you should be looking at — is the difference between comparing investments fairly and being impressed by the bigger number.

ROI: the total change

ROI measures how much an investment gained or lost relative to what it cost, over the whole period you held it. ROI = (what you got back − what you put in) ÷ what you put in × 100. Turn $10,000 into $18,000 and your ROI is 80%.

A complete ROI counts everything on both sides. “What you put in” includes purchase costs such as fees and commissions, and “what you got back” includes any income received along the way, such as dividends or rent. Buy something for $10,000 plus $500 of costs, collect $1,200 of income, and sell it for $14,000: you put in $10,500, got back $15,200, and your ROI is about 44.8%.

CAGR: the yearly pace

CAGR answers a different question: what steady yearly growth rate would turn the starting value into the ending value over the same number of years? CAGR = (ending value ÷ starting value)^(1 ÷ years) − 1. Turning $10,000 into $18,000 over five years is a CAGR of about 12.5% — growing 12.5% a year, compounded, for five years multiplies the money by 1.8.

ROI and CAGR are not competitors. CAGR is simply ROI converted into a yearly rate, which is why it is also called the annualized return.

Why ROI alone can mislead

ROI ignores time. Compare two investments: one turned $10,000 into $18,000 over five years (80% ROI), the other turned $10,000 into $16,000 over two years (60% ROI). On ROI, the first looks better. On CAGR, the second grew about 26.5% a year against 12.5% — more than twice as fast. If you could have reinvested the second investment’s proceeds for the remaining three years, it would very likely have come out ahead.

The longer the holding period, the bigger ROI looks, which makes it a poor tool for comparing investments held for different lengths of time. Whenever the periods differ, compare annualized figures.

Why CAGR can mislead too

CAGR describes a smooth path that never happened. An investment that rose 80% in year one and then went nowhere for four years has the same five-year CAGR as one that rose steadily. CAGR tells you where you ended up, not how bumpy the ride was or how far it fell along the way.

CAGR also only looks at the start and end values, so it works best for a single sum invested once. If you added or withdrew money during the period, a simple CAGR on the start and end balances will mix your contributions in with your returns.

Never average yearly returns

A common mistake is to calculate an annual return by averaging each year’s percentage change. Suppose an investment rises 50% one year and falls 50% the next. The average of +50% and −50% is 0%, which suggests you broke even. In fact $10,000 became $15,000 and then $7,500 — a 25% loss, and a CAGR of about −13.4% a year.

Losses hurt more than equal-sized gains help, because the loss is applied to a bigger number. CAGR captures this correctly; a simple average does not. When someone quotes an “average annual return”, it is worth asking which kind of average they mean.

Which one to use

Use ROI to answer “how much did this make me in total?” — it is the right number for judging a single completed deal, and it can include every cost and every payment received.

Use CAGR (or annualized ROI) to answer “how fast did my money grow?” — it is the right number for comparing investments held for different lengths of time, or for comparing an investment with a savings rate, a bond yield, or inflation, all of which are quoted per year.

Finally, remember that both are nominal. To know how much your purchasing power actually grew, subtract the effect of inflation — explained in nominal vs. real return.

Calculate total and annualized return, including costs and income, with the ROI calculator, or find the yearly growth rate between any two values with the CAGR calculator.