Compound Annual Growth Rate - CAGR

It's all about returns over time. How they grow. Compound. Grow up. Get Bar Mitzvah'd or Quinceanera'd. And then get married, and then triple in size from either pregnancy or depression.

Um...yeah. So the average annual return is a common measure for mutual funds, but calculating the compound annual growth rate (CAGR) is even better. Assuming the investment is really compounding over a certain period of time, you can assess the growth rate from when you made the first investment until the present time.

The reason the CAGR presents a truer picture is that the average annual return does not take into account compounding, so it can overestimate the growth of an investment. The CAGR is an average that calculates the rate at which the investment would have grown if it had compounded at the same rate each year.

The formula for CAGR is:

CAGR = (Ending Value / Beginning Value)1 / n - 1

...where n is the number of periods in months or years.

You invest $2,000 in the We Always Compound fund for five years. Here is the value of your investment at the end of each year:

Year Ending Value

1 $1,500
2 $2,000
3 $6,000
4 $8,000
5 $10,000

You can calculate the CAGR of the investment as:

CAGR = (10,000 / 2,000)1/5 - 1 = .37973 = 37.97%

And yeah, this'll be a lot easier if you use a financial calculator, or Excel.

If you had simply taken an average of the returns from year one (-25%) and two (33%) it would come out to a positive 4%. But actually, the growth was 0%, since you ended up with the same $2,000 you started with.