In finance and investing, whether you’re looking at stocks or savings accounts, it’s often useful to calculate your returns to measure how you’re doing. One way is to calculate your compound annual growth rate or CAGR. The best way I’ve seen this defined is in the investopedia.com dictionary (hence the link), which says:
CAGR isn’t the actual return in reality. It’s an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns.
Here’s the general formula for calculating CAGR:
CAGR = (ending amount / beginning amount)(1 / # of years) – 1
When you look at mutual fund performances, the 1 year, 3 year, 5 year, and 10 year average annual returns you see are essentially CAGR calculations. For example, if you started out with an investment of $100 in your savings account, and after 5 years, this amount grew to $200, then your investment would have grown 100%. However, your compound annual growth rate would be 14.87%. In other words, if you had earned interest at a steady 14.87% each year for five years, you would have ended up with $200. I’ve included an excel template for calculating CAGR under the Tools & Calculators section of this website. (Update: I’ve added an online CAGR calculator.)
CAGR and mutual funds
I happened to find a website for a professional suite of tools called StyleAdvisor through Google one day while looking for mutual fund performance measures. They had an interesting writeup about one of their tools that measures how well mutual funds have performed in which they emphasized end-point bias in mutual fund performance. Basically, if a fund has underperformed for several years but has one really good year, its CAGR can still look very good because what’s happening essentially is that the returns of the one very good year are getting spread out (averaged) across all the other underperforming years. For this reason, it’s worth looking out for long-term and consistently good performance in a mutual fund by using rolling averages instead of focusing on average annual return rates. As a side note, it seems that StyleAdvisor does offer some good tools, but unfortunately their price tag shows they’re definitely geared toward institutional investors!
An interesting thought
After reading StyleAdvisor’s explanation, I realized the CAGR game might apply to stock investments as well. Suppose you invested in a stock or index. Then the longer you hold the stock, the greater the chance that you’d hit a year with abnormal returns (good or bad). Then, assuming you could find good companies or long-term prospects to invest in, and that the trend of the stock market tends to be upward instead of downward over long enough periods of time, it seems that you have a better chance of having good overall returns (as measured by CAGR) the longer you held the investments.
By the way, it seems to me that consistent and steady performance (or even matching the market) is underappreciated in the general investing community. People tend to focus on beating the market or trying to get double-digit returns without any real rationale or logical reasoning as to why this should be achievable. Jason Zweig, the commentator in the most recent edition of The Intelligent Investor, wrote something that really struck me, assuming it’s true:
Back in 1982, the average net worth of a Forbes 400 member was $230 million. To make it onto the 2002 Forbes 400, the average 1982 member needed to earn only a 4.5% average annual return on his wealth — during a period when even bank accounts yielded far more than that and the stock market gained an average of 13.2%. So how many of the Forbes 400 fotrunes from 1982 remained on the list 20 years later? Only 64 of the original members — a measily 16% — were still on the list in 2002. (p. 185)
Guess consistently good performance, even if underappreciated, is really worth seeking!