CAGR in investments: a key metric for evaluating portfolio profitability

In the world of finance, there is one indicator that allows investors to objectively assess the effectiveness of their investments over a long period. This is the compound annual growth rate (CAGR), which represents the annual rate of return you would have achieved if your investments grew at a consistent rate each year, accounting for reinvested earnings.

Why CAGR differs from the simple rate of return

Unlike simple profit calculations, CAGR considers one critically important factor – compounding, or the effect of accumulation. This means that the profit earned in the first year generates its own profit in subsequent years. That’s why this metric more reliably describes the actual growth path of your capital compared to other calculation methods.

Investors use CAGR to compare different assets and determine which ones demonstrated better dynamics. It also helps evaluate the prospects of future investments and analyze how your portfolio performed in past periods.

How to calculate CAGR: step by step

The CAGR formula looks like this:

CAGR = (Ending value / Starting value)^(1 / Number of years) – 1

To apply this formula in practice, follow this sequence:

1. Divide the current value of your investment by its initial value.
2. Raise the result to the power of one divided by the total number of years invested.
3. Subtract one from this number.
4. Multiply by 100 to convert the result into a percentage.

Practical significance of CAGR for long-term planning

It is important to understand that CAGR is not the actual rate of return but a hypothetical figure showing what the average annual return would be under uniform growth conditions. However, this standardized figure provides investors with the ability to quickly compare different assets and strategies on a common basis.

Using this indicator, you can objectively evaluate the effectiveness of each investment, track your portfolio’s progress, and make informed decisions about future investments. Understanding CAGR becomes the foundation of successful long-term investment planning and helps avoid getting lost in the multitude of available investment opportunities.

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