WSJ: Understanding a Mutual Fund's Average Annual Return

What does it mean when a mutual fund reports its average annual return over a period of, say, three or five years? It isn't exactly what you might think. What's more, computing the figure yourself will require more than the general arithmetic you use in other areas of your life.
Consider a person who invests $100 and has a 10% loss one year and a 10% gain the next. That might seem to be an average return of zero. But the investment would actually be down one dollar in value—dropping 10% to $90 the first year, then growing 10% to $99 the next.Specifically, average annual return can't be determined by calculating the simple average of three or five one-year returns—the way you would calculate the average height of two people who are 5 and 6 feet tall, respectively. That's because investment returns are volatile and the results compound year after year, says Paul Justice, director of data methodology at Morningstar Inc.
So fund companies and data providers typically report multiyear returns as "compounded average annual returns," or geometric returns, which reflect how a series of returns affect an initial investment. The annualized return in our example is about negative 0.5%.
The details of the calculation aren't important because fund companies will do the sums for you.
What is important to remember is that even seemingly small differences in annual returns compound over many years to create big dollar differences in how an investment grows. If you started with $10,000 and invested it for a couple of decades, a difference in average annual return of, say, half a percentage point could easily mean a difference of a few thousand dollars at the end of the period.
Quoted fund returns generally include the reinvestment of dividends and capital-gains distributions. They are net of operating expenses, but typically not of any sales charges.
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