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What is the Compound Annual Growth Rate (CAGR)?
Compound annual growth rate (CAGR) is a way to quantify the performance of an asset over a given period, assuming all generated profits were reinvested over that period.
The CAGR describes the rate at which an investment would have grown had it grown at the same rate every year. Therefore, the CAGR overlaid on a chart will be linear.
CAGR is a representational figure, and investors often use it to compare portfolio performance or project future growth of an investment.
Compounding – A Brief Background
Before continuing with CAGR, we think it’s important to provide some background on the concept of compounding.
Ideally, your investment will grow over time. As it grows, the return you make on your investment at certain intervals is dependent on the value of your investment at the time returns are calculated.
As returns are added to the initial investment amount, the accrued interest continues to increase.
In other words, the gains on an investment get reinvested back into the same investment. This is known as compounding — a process Albert Einstein famously called “the eighth wonder of the world.”
Rather than a linear return, compounding returns increase over a set period of time in a parabolic fashion.
The latter stages of growth in an investment left to compound is why it’s suggested to invest as early as possible.
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How to Calculate the Compound Annual Growth Rate (CAGR)
The CAGR is not an “average” return – it is a compounding operation that takes the length of time of an investment into account. Here’s an example:
In 2020, despite a global pandemic, dollar-printing and market hysteria enabled the S&P 500 to return 16.26%, growing your balance to $29,967.
Let’s say that 2021 turns south and the S&P 500 closes down 10% on the year to make things interesting. Your account will show a balance of about $26,970.
If you simply average out your returns over 3 years, you’d end up with an average return of 11.7% each year.
A $25,000 initial investment that grows 11.7% annually over three years will increase to about $28,000 – not $26,970, which is the actual figure in your hypothetical trading balance.
To calculate CAGR, you must use the formula below with “n” representing the number of years:
CAGR = (End Value / Start Value)1/n – 1
Using this formula, we see that:
End Value = $26,970
Start Value = $20,000
n = 3
This gives us a Compound Annual Growth Rate of 10.48% over this 3-year period, which is not the average 11.7% annual return.
Why the CAGR is Important
You might be wondering why the big fuss between averaging and compounding. After all, 1% isn’t all that much in the grand scheme of things.
The example above is a real-world scenario involving an index, but there are certain investments out there with far wider ranges in profit and loss each year, and the average can get quite off in those circumstances.
This is why CAGR would be useful for individuals to understand, but businesses must think about it much differently.
That 1% could be a huge factor in whether or not a project meets its budgetary requirements, so CAGR is a much better method of accurately reporting an investment’s return over a long period of time than simple averaging.
One percent of a large number can be a very large number.
How to Use the Compound Annual Growth Rate
It’s important to remember that the CAGR is mostly a method of visualizing the returns on an investment over a period of time.
CAGRs are often used to predict the future, but the input data is based on the past. As the age-old adage goes: “the past is not indicative of the future.”
Projection formulas can help you understand the minimum expected return per year an investment needs to make to be viable.
However, the CAGR is another way to represent past performance. History doesn’t always repeat itself, but sometimes it rhymes.
Other CAGR Uses
While CAGR is a great tool for showing annualized returns over a longer period of time, it can also be used to compare two or more investments side by side.
If budget cuts are coming, the CAGR would be a good barometer to compare investments over differing lengths of time.
Let’s say you have a 10-year-old project that, on paper, is performing much better than a 5-year-old project.
However, after calculating the CAGR of the two, it’s obvious that the 5-year-old project yields far better-annualized results than the 10-year-old project.
The board has a better idea of which project to cut and which to grow by simply reviewing CAGR.
Obviously, there would be other considerations involved than looking at one figure, but it helps illustrate how CAGR can be used to make decisions.
What does the CAGR tell you?
CAGR tells you the annualized returns of an investment over a specific period of time. With volatility in nearly any investment, the CAGR essentially flattens the return chart and gives an idea of how an investment has performed each year.
It’s important to remember that CAGR is not an average. As with all compounding formulas, it takes the length of time you’ve held an investment into account and provides a relatively good representation of annualized performance.
While CAGR is useful in a simple comparison, it really should only be used in those circumstances where investors are looking for long-term investments. Mutual fund companies will report CAGR figures regularly, but they may not represent the actual performance each year an investment is likely to experience.
What is CAGR in simple terms?
The CAGR gives a single percentage return for each year you’ve held an investment. While an investment’s return each year usually varies, the CAGR can give you an idea of how the investment is doing each year after a length of time.
What does a 3-year CAGR tell you?
A 3-year CAGR will take the ending balance of an investment after 3 years, compare it with the beginning balance, and provide the same annualized percentage return for each of the 3 years you held the investment. While the actual annual return might have been something like +5%, +50%, and -12%, the 3-year CAGR will provide the same percentage return for each of the 3 years.
What is CAGR in the industry?
Compound annual growth rate is used by many in the finance industry to compare how any financial instrument or even financial sector is performing over a specific number of years.
While CAGR is a great visualization method for past returns, it should not be relied upon blindly. The CAGR is best used with ample context. Investments that have wide ranges in profit and loss over a period of time and simply looking at the CAGR would not prepare investors for the roller coaster of returns each year.
Bottom Line: Compound Annual Growth Definition (CAGR)
The compound annual growth rate is a useful tool for visualizing the annualized performance of an investment over a set period of time. The compounding component is key.