What is CAGR?

Understanding the Compound Annual Growth Rate and why it matters for your investments

Table of Contents

1Definition of CAGR

CAGR stands for Compound Annual Growth Rate. It is the geometric mean rate of return that describes the constant annual rate at which an investment would have grown if it had compounded over the entire period.

Unlike simple annual growth rates, CAGR accounts for the compounding effect that occurs when previous gains contribute to future gains. It provides a "smoothed" growth rate that helps investors understand the steady rate at which an investment would have grown if it had increased at the same rate each year.

CAGR is useful for calculating and determining returns for anything that can rise or fall in value over time.

2The CAGR Formula

The formula for calculating CAGR is:

CAGR = (Vf / Vi)1/n - 1
Where Vf is the final value, Vi is the initial value, and n is the number of years

This formula calculates the constant rate at which an investment would need to grow each year to reach its final value from its initial value over the specified time period.

3Example Calculation

CAGR Example

Let's say you invested $10,000 in a portfolio, and after 5 years, your investment grew to $16,105.

Initial Investment:$10,000
Final Value:$16,105
Time Period:5 years
CAGR:10%

Using the CAGR formula: ($16,105 / $10,000)1/5 - 1 = 0.10 or 10%

This means your investment grew at a steady rate of 10% per year over the 5-year period.

4Why CAGR Matters

Smooths Returns

CAGR smooths out the volatility of returns, providing a clearer picture of an investment's performance over time.

Enables Comparisons

CAGR allows a standardized comparison across assets, but should be complemented by risk metrics like volatility or drawdowns.

Projects Future Growth

CAGR can illustrate past trends, but projecting it forward assumes stationarity and ignores market regime shifts.

Measures Endpoint Performance

CAGR reflects the total return between two points in time. It ignores all intermediate fluctuations and does not capture path dependency.

5Limitations of CAGR

While CAGR is a valuable metric, it has some limitations:

  • Ignores Volatility: CAGR doesn't show the volatility or risk experienced during the investment period.
  • Path Independence: Two return paths with identical start and end values will have the same CAGR, even if their interim trajectories are radically different.
  • Time-Sensitive: The starting and ending points chosen can significantly impact the calculated CAGR.
  • Accounting for Cash Flows: CAGR is not applicable for investments with irregular cash inflows or outflows. For that, use the Internal Rate of Return (IRR).

Related Financial Terms

Standard Deviation

Variability of returns

Sharpe Ratio

Risk-adjusted measure of return

Sortino Ratio

Risk-adjusted measure of return

Frequently Asked Questions

CAGR provides a smoothed annual growth rate, ignoring interim volatility. For investments with fluctuating returns, CAGR can mask periods of significant losses or gains, offering an incomplete picture of the investment's performance and risk profile.

While CAGR calculates the average annual growth rate, IRR considers the timing and magnitude of cash flows, providing a more comprehensive measure of an investment's profitability, especially when cash flows are irregular.

Yes, CAGR standardizes growth rates over time, allowing for comparisons across investments with varying durations. However, it's essential to consider other factors like risk and cash flow patterns for a holistic evaluation.

CAGR assumes a constant growth rate, which may not reflect real-world scenarios where growth can be erratic. Relying solely on CAGR in projections can lead to overly optimistic or pessimistic forecasts, underscoring the need for more dynamic modeling techniques.