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.
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.
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.
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