How Is CAGR Calculated and What Does It Tell You?
CAGR is calculated by dividing the ending investment value by the beginning value, raising the result to the power of 1 divided by the number of years, and subtracting 1. For example, an investment growing from $10,000 to $20,000 in 7 years has a CAGR of about 10.4%. CAGR tells you the consistent annual return needed to reach the final value from the starting value, making performance comparisons straightforward.
Why Is CAGR Better Than Simple Average Returns?
Simple arithmetic averages of annual returns can be misleading because they ignore the sequence of returns and compounding. If an investment gains 100% one year and loses 50% the next, the arithmetic average is 25%, but the actual return is 0%. CAGR correctly shows the actual compounded growth, accounting for the impact of losses on the total amount invested rather than treating each year's return independently.
How Is CAGR Used in Financial Planning?
CAGR is used to project portfolio growth, compare mutual fund and ETF performance, evaluate business revenue growth, and set realistic retirement savings targets. The U.S. stock market's long-term CAGR of approximately 10% (nominal) or 7% (real, inflation-adjusted) is the most commonly used planning benchmark. Using CAGR to model your own investments helps you set realistic targets and identify whether you're on track to meet financial goals.
Frequently asked questions
What is a good CAGR for a stock portfolio?
The S&P 500 has historically delivered a CAGR of roughly 10% per year before inflation and 7% after inflation over multi-decade periods. A CAGR significantly above this typically comes with higher risk. For individual stocks or funds, comparing their CAGR to a relevant benchmark (like the S&P 500) over the same period is the most meaningful performance assessment.
What is the difference between CAGR and IRR?
CAGR assumes a single lump-sum investment and measures its growth rate over time. Internal Rate of Return (IRR) accounts for multiple cash flows at different times — like regular contributions to an investment account. For portfolios with ongoing contributions or withdrawals, IRR is more accurate than CAGR for measuring actual investment performance.