ROI, return and CAGR
To know whether an investment went well it is not enough to look at how much money you made: you have to relate it to how much you invested and for how long. Here are the three measures you need.
ROI: return on investment
ROI (Return On Investment) measures the gain relative to what you put in, as a percentage:
ROI = (final value − initial investment) / initial investment × 100
Example: you invest €1,000 and get back €1,300. ROI = (1,300 − 1,000) / 1,000 = 30 %.
ROI is intuitive, but it has a huge flaw: it says nothing about time. A 30 % in 1 year is excellent; 30 % in 10 years is mediocre. To compare investments of different durations, you need to annualize.
Return: the general term
Return is, in general, what you make relative to what you invested. ROI is one way to express it. But when we talk about multi-year investments, we care about the annualized return: the percentage you would make each year, on average, taking compound interest into account.
CAGR: the annualized return
CAGR (Compound Annual Growth Rate) is the constant annual percentage that, applied with compound interest, takes your investment from the initial value to the final value. It is the standard figure for comparison.
CAGR = (final value / initial value) ^ (1 / years) − 1
Example: those €1,000 that became €1,300 in 4 years. CAGR = (1,300 / 1,000)^(1/4) − 1 = (1.3)^0.25 − 1 ≈ 6.8 % a year.
So although the total ROI was 30 %, the real annual return was 6.8 %. That is the honest figure to compare with other options.
Why the difference matters: two examples
| Investment | Total ROI | Years | CAGR |
|---|---|---|---|
| A | 30 % | 4 | 6.8 % |
| B | 30 % | 10 | 2.7 % |
Same ROI, but investment A was more than twice as profitable per year. Without annualizing, they would look identical.
Watch what ROI leaves out
For the figure to be realistic, account for:
- Fees and taxes: subtract them from the final value for a "net" ROI.
- Inflation: a 6.8 % nominal with 3 % inflation is a ~3.8 % real return.
- Intermediate contributions: if you added money along the way, simple ROI falls short; there you use the IRR (a variant that spreads each contribution over time).
The mistake that inflates your numbers: CAGR vs. average
An investment that rises 100 % then falls 50 % is back where it started: a CAGR of 0 %. But the arithmetic mean of +100 % and −50 % is +25 %. If someone sells you a fund on its "average annual return", be wary: with volatility the average is always higher than the real CAGR, and the CAGR is what actually ends up in your pocket. It's the same reason recovering from a 50 % drop requires a 100 % gain, not 50 %.
What to actually look at
Always compare by CAGR, not by total ROI or by average. Subtract fees and taxes for the net CAGR, and deduct inflation for the real one. And if you made contributions along the way, simple ROI falls short: use the IRR, which weights each euro by the time it stayed invested.
This is educational information, not investment advice.