What is the CAGR formula and why do investors need to understand it?

Question

When building a personal investment portfolio, accurately measuring growth performance is a crucial move. The annual compound growth rate (CAGR) is the most effective tool to do this, allowing you to compare the effectiveness of different investment decisions over a long-term period.

What is CAGR - Basic Concept

The annual compound growth rate is a financial indicator designed to reflect the increase or decrease in the value of an investment each year. Unlike simple calculation methods, CAGR accounts for the effect of compounding — that is, profits generated from the profits themselves. This makes it a more accurate measure when comparing investment opportunities or reevaluating past results.

In other words, CAGR indicates the rate at which an investment would need to grow if it increased at a steady annual rate, assuming profits are reinvested each year.

How to Calculate CAGR - Formula and Steps

The CAGR formula is quite simple but powerful:

CAGR = (End Value / Start Value)^(1 / Number of Years) – 1

To apply this formula in practice, follow these steps:

Step 1: Divide the value of the investment at the end by the value at the beginning
Step 2: Raise the resulting number to the power of (1 divided by the total number of years)
Step 3: Subtract 1 from the result
Step 4: Multiply by 100 to convert to a percentage

This method provides a comprehensive view of actual growth, eliminating short-term market volatility.

Why is CAGR an important metric?

CAGR does not reflect the actual profit you receive but instead serves as a theoretical indicator. It simulates a scenario where an investment grows at a steady rate year after year.

The main benefit of CAGR is that it converts complex performance into a single number, helping you:

Quickly evaluate the performance of any investment
Fairly compare different investment opportunities
Plan long-term finances with clear data

By standardizing different time periods into a single measure, CAGR becomes an indispensable tool in portfolio management and smart investment decision-making.