The compound annual growth rate (CAGR) is basically the average yearly growth rate of an investment over a span longer than a year. It’s a reliable method for figuring out returns on individual assets, investment portfolios, or anything that can change in value over time.
You’ll often hear CAGR thrown around by investment advisors trying to show off their expertise or by funds highlighting their performance.
Learn more about Compound Annual Growth Rate
CAGR is a formula that gives you a smooth rate of return over time. It helps you figure out what your investment would earn if it were compounded annually. This number shows investors what they actually end up with at the end of their investment period.
Let’s say you put in $1,000 at the start of 2022, and by the end of the year, your investment grew to $3,000, giving you a 200% return. But then the market took a hit the following year, and you lost 50%, leaving you with $1,500 by the end of 2023.
If you just look at the average annual return, it might seem like you made 75% (the average of that 200% gain and the 50% loss). However, your actual ending amount was $1,500, not $3,065, based on a 75% annual rate over two years. To really understand your annual return for that period, you need to calculate the CAGR.
Calculation of CAGR (Compound Annual Growth Rate)
To find the CAGR, you need to take the nth root of the total return, where n represents the number of years you’ve held onto your investment. This is essentially calculating the geometric mean. For instance, if your total return over two years is 50%, you’d take the square root of that, which gives you a CAGR of 22.5%.
The table shows the annual returns, CAGR, and average annual return for this hypothetical portfolio. It highlights how CAGR smooths out the returns over time. Even though the annual returns fluctuate, the final value remains consistent.
CAGR is a great way to assess how different investments have fared over time. It addresses the shortcomings of using the arithmetic average return. Investors can use CAGR to compare the performance of one stock against others in the same sector or against a market index. It’s also useful for comparing the historical returns of stocks with bonds or savings accounts.
Conclusion
CAGR is a handy tool for checking out investment options, but it’s not the complete picture. Investors can look at the CAGRs of different investments over the same time frame to compare them. However, it’s also important to consider the risks involved. For that, using another metric like standard deviation can be really helpful.