What is CAGR?
CAGR, or compound annual growth rate, is the average rate of exponential growth that takes place over a certain period.¹ CAGR provides a standard annual rate and helps in comparing returns of two investments that may have different tenors.
How to calculate CAGR
The mathematical expression for CAGR is:
While calculating CAGR, it's assumed that compounded growth takes place. In other words, the principal and the interest are growing at this rate.
This is a standard way of representing returns generated over a period of time. By using CAGR as a benchmark, an investor can determine which investment generates better returns. If the CAGR is known, someone planning for retirement can determine the amount of money that they need to invest today. This makes it a helpful tool for retirement planning.
However, the CAGR method does not depict the risk level of an investment because only the final and initial values are required. The value of an investment may rise or drop sharply in the intermediate periods, but this information is not captured in the CAGR method.
Example
Sam is planning for his retirement and has $500,000 to invest. He estimates that he would need $1 million for his retirement, which will take place in ten years. He will not make any further investment into the fund. Based on this information, the CAGR of his investment would be (1,000,000/500,000)1/10 – 1 or 7.18%.
References
- Compound Annual Growth Rate (CAGR). Gartner. https://www.gartner.com/en/information-technology/glossary/cagr-compound-annual-growth-rate
Please note that this article is for educational and informational purposes and is believed to be accurate and reliable as of posting date but may be subject to change. The example above is hypothetical and is for illustrative purposes only. Alpaca does not provide investment, tax, or legal advice. Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
There is no guarantee that any investment strategy will achieve its objectives. All investments involve risk and the past performance of a security or financial product does not guarantee future results or returns. There is always the potential of losing money when you invest in securities or other financial products. Investors should consider their investment objectives and risks carefully before investing.
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