A:

The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below is an overview of some of its uses and limitations.

Average Returns vs. CAGR

Consider an investment that starts with a value of $5,000. During the first year, the value falls by 50% to $2,500. The next year, the investment doubles and returns to a value of $5,000. The investment since inception obviously just broke even, but the average return ends up to be 25%, or the average of a 50% drop and a 100% return. In this case, the CAGR return is 0%, which would be considered more accurate than a 25% average return. The CAGR is superior to average returns when analyzing time series data (time intervals) because it considers the fact that investment returns compound over time.

Smoothed return

Despite the superiority of CAGR over average returns, the CAGR does have its limitations. One limitation is that it assumes a smoothed return over the period that’s measured. In reality, investments experience significant short-term ups and downs. Instead, the CAGR only looks at the beginning and end value and assumes a constant return in between.

Data Mining

CAGR is also subject to manipulation as the time period used can be controlled by the user. For instance, a five-year return period can be shifted by a year to avoid a negative period (such as 2008), or to include a period of strong performance (such as 2013).

Multiple Cash Flows

CAGR is very straightforward when there is a beginning and ending value, and set period of time. But in reality, investments, such as mutual funds, have continuous cash inflows and outflows and are required to report monthly, quarterly, annual, and even daily returns. Relatively quickly, portfolio accounting software becomes needed as the math is difficult to be done by hand.

RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The concept of CAGR is relatively straightforward and requires only three primary inputs: an investments beginning value, ... Read Answer >>
  2. How do you calculate CAGR?

    Find out how to understand and use the compound annual growth rate formula, and find out why it helps put an uneven performance ... Read Answer >>
  3. What are the main differences between compound annual growth rate (CAGR) and internal ...

    The compound annual growth rate (CAGR), measures the return on an investment over a certain period of time. The internal ... Read Answer >>
  4. What is the difference between a company's annual return and its annualized return?

    Understand the importance of calculating a company's annual return and its annualized return, and learn the differences between ... Read Answer >>
Related Articles
  1. Investing

    Compound Annual Growth Rate: What You Should Know

    The CAGR is a good and valuable tool to evaluate investment options, but it does not tell the whole story.
  2. Investing

    The Most Accurate Way To Gauge Returns: The Compound Annual Growth Rate

    The compound annual growth rate, or CAGR for short, represents one of the most accurate ways to calculate and determine returns for individual assets, investment portfolios and anything that ...
  3. Investing

    Learn Simple And Compound Interest

    Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple interest or compound interest.
  4. Financial Advisor

    Compound Annual Growth Rate (CAGR)

    The compound annual growth rate is an important tool for measuring investment performance and comparing it across asset classes. Discover how it is calculated and how it can inform your investment ...
  5. Investing

    How To Calculate Your Investment Return

    How much are your investments actually returning? Find out why the method of calculation matters.
  6. Managing Wealth

    Morgan Stanley On the Trends in Asset Management (MS)

    Learn about trends in the asset management industry and future prospects for its growth, according to a May 2016 Morgan Stanley report.
  7. Retirement

    Using Compounding to Boost Retirement Savings

    Allowing growth on your investments to compound over time gives you immense returns when saving for retirement.
  8. Investing

    Calculating Annualized Total Return

    The annualized total return is the average return of an investment each year over a given time period.
  9. Investing

    5 Stock Market Metrics Explained

    Learn how to evaluate a company's performance using metrics such as ROE, EPS and P/E ratio.
  10. Investing

    Accelerating Returns With Continuous Compounding

    Investopedia explains the natural log and exponential functions used to calculate this value.
RELATED TERMS
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  2. Average Annual Growth Rate - AAGR

    The average increase in the value of an individual investment ...
  3. Compound Return

    The rate of return, usually expressed as a percentage, that represents ...
  4. MAR Ratio

    A measurement of returns adjusted for risk that can be used to ...
  5. Return

    The gain or loss of a security in a particular period. The return ...
  6. Annual Return

    The return an investment provides over a period of time, expressed ...
Hot Definitions
  1. Demonetization

    Demonetization is the act of stripping a currency unit of its status as legal tender and is necessary whenever there is a ...
  2. Investment

    An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic ...
  3. Redlining

    The unethical practice whereby financial institutions make it extremely difficult or impossible for residents of poor inner-city ...
  4. Nonfarm Payroll

    A statistic researched, recorded and reported by the U.S. Bureau of Labor Statistics intended to represent the total number ...
  5. Conflict Theory

    A theory propounded by Karl Marx that claims society is in a state of perpetual conflict due to competition for limited resources. ...
  6. Inflation-Linked Savings Bonds (I Bonds)

    U.S. government-issued debt securities similar to regular savings bonds, except they offer an investor inflationary protection, ...
Trading Center