What Is CAGR and How Do You Use It to Evaluate Investments?
In plain English
Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified time period longer than one year, assuming profits are reinvested. It smooths out the volatility of annual returns to produce a single, comparable growth rate. The formula is: CAGR = (Ending Value / Beginning Value)^(1/Years) - 1. It is the most useful metric for comparing investment performance across different time periods.
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.
Keep exploring
Related terms
Time Value of Money
A dollar today is worth more than a dollar tomorrow because today's dollar can be invested to earn returns. This foundational concept underpins nearly every financial decision.
Opportunity Cost
Opportunity cost is the value of the next-best alternative you give up when making a financial decision. Every financial choice has an opportunity cost, even when no money changes hands.
Bear vs. Bull Market
A bull market is a period of rising stock prices, typically defined as a 20% gain from recent lows. A bear market is a period of falling prices, defined as a 20% decline from recent highs. Knowing which phase the market is in helps calibrate your investment strategy.
Purchasing Power
Purchasing power is the quantity of goods and services that a unit of currency can buy. Inflation erodes purchasing power over time, making it essential to invest in assets that grow faster than prices.
Inflation
Inflation is the rate at which the general price level of goods and services rises over time, reducing the purchasing power of money. It affects everything from grocery bills to retirement savings.