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CAGR

 

CAGR is used to measure return and means compound annual growth rate. This type of return measurement is very popular in investment finance because interest also earns interest and power of compounding cannot be ignored. And it is exactly what compounded growth rate does: it shows what average percentage is earned on annual basis by investments

 

There are few important advantages of CAGR against simple arithmetic average:

  • Capital earns capital, and interest (or dividends) is normally reinvested. This rate includes the interest that is received from reinvested capital.
  • Power of compounding gives very significant difference over long period and this must be taken into account. 

 

However, there is not much meaning to calculate compounded annual return on investment for very short period (1-2 years), but it is the only way to measure investment performance rate correctly over longer period. 

 

CAGR formula


CAGR = (Portfolio end value / Portfolio beginning value) ^ (1 / Number of years) - 1

 

Basically, this growth ratio is calculated as geometric mean and the same principal is used for IRR (internal rate of return) calculation. CAGR can also be calculated as IRR using end and beginning values.

 

Of course, when compound annual growth rate is calculated, there cannot be any additional inflows or outflows in the portfolio during the calculation period, or otherwise such calculation will be meaningless (in such case IRR can be used).

 






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