Compound Annual Growth Rate (CAGR) is one of those investing terms that no one ever understands until you give a simple example. It’s funny because the explanation undermines the simplicity of the calculation of the growth rate in question.
Quite simply, CAGR is the the fixed rate of return that will give you the exact same growth of the investment in question. Let me give you an example:
A portfolio with $1,000 becomes $1,200 by year one, $1,500 by year two, and $2,500 by year three. The CAGR is simply 0.3572, or in other words, the portfolio enjoyed a 35.72% return annually.
Here’s the formula so you can calculate CAGR yourself.
CAGR = ((ending value / beginning value) ^ 1/compound period)) – 1
Where CAGR is Used
This growth rate is used often when comparing growth of two elements because this measure reduces the effects of volatility. It is also used in business to report on a specific part of its operations, like revenue, subscriber growth etc.
What This Means to Us
With this information, you can easily compare two different investments’ historic returns. Also, it is a neat tool to use in calculating your own portfolio returns to see how fast it’s growing.
In your own investment portfolio, remember though that you have most likely made deposits or withdrawal. Therefore, don’t be alarmed when you see a 80% CAGR and do not falsely believe in your investment genius!
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{ 4 comments… read them below or add one }
I think the correct CAGR formula is
CAGR = ((ending value / beginning value) ^ (1/compound period)) – 1
Good catch
It’s been fixed and thanks for pointing it out!
is the compound period in months or years?
CAGR is an annual rate so the period is in years.