The importance of compound growth rates when it comes to investing

Compound annual growth rate (also known as CAGR) is a measurement of an investment’s average performance over a specified period of time.

As an investor, you may examine your portfolio on a daily, weekly, quarterly or annual basis. Each of these glimpses will show you how your investments are performing at the moment. For instance, you may look at the daily increase or decrease in value, or track an investment’s growth or decline over the past quarter.

Those measurements can be helpful for regular updates. But if you’re a long-term investor, the incremental gains and losses are not the measurements that really matter. It’s the cumulative growth of an investment over a number of years that really matters, if you’re in it for the long term.

For instance, if you held an investment for five years, the growth of that investment is likely to fluctuate from one year to the next. But for the sake of comparing that investment’s performance to other potential investments, it can be helpful to look at how much it grew each year, on average, during the entire five years. That’s where the CAGR comes in.

What is the compound annual growth rate?

The CAGR of an investment is the annual rate of return that would be required for an investment to grow from its beginning balance to its ending balance for a set length of time. It assumes that all profits are reinvested at the end of each year throughout the lifetime of the investment.

For the sake of easy math, say you had an investment that grew 20 percent during the first year, but grew only 10 percent during the second year. Even though there was a 10-percent drop in growth during the second year, the average growth rate over the two-year term was 15 percent (the average of 10 and 20).

That’s an easy example but it doesn’t take into account the “compound” part of compound annual growth rate. (Remember, compounding is the process of earning returns on an initial investment plus any returns on that investment that you already earned.)

That means figuring the true CAGR is more complex because it assumes the 20 percent gain from the first year will be reinvested, so the second year’s 15 percent growth is based on a larger principal investment.

So, how do you calculate CAGR?

To calculate the CAGR of an investment, you have to use a special formula that takes into account the compounding effect of reinvesting returns each year. The formula is:

(EV/BV) 1 / n – 1

EV = the investment’s ending value

BV = the investment’s beginning value

n = the number of years the investment is held

You can also use an online compound annual growth rate calculator to determine CAGR.

How should this information affect my investing?

When you invest in the market, volatility is a given. And intellectually, investors may know that ups and downs are to be expected, but when the markets are in the throes of a steep downturn, it can feel tempting to give up.

However, giving up because of a drastic dip in the market is like abandoning your road trip because you have to take a detour. The detour may take you down some curvy, unfamiliar roads. But in the end, you’ll arrive at the same destination as if you’d stayed on the interstate the whole time. The CAGR shows you the smooth, freeway version of your investment’s growth, without worrying about all the ups and downs.

For instance, say you invested $1,000 in a fund that mirrors the S&P 500 index (which measures the stocks of 500 of the largest publicly traded U.S. companies) and left the money alone for 10 years, reinvesting the earnings each year. You would likely see your investment grow exponentially—and watch it fall drastically—over the years. But despite the frequently sharp increases and decreases, the S&P 500 averages a 7 percent annual return. At that rate, your investment would almost double in 10 years, for a total of $1,967.

If you put the same $1,000 in a high-yield savings account with an interest rate of 1.5 percent (keep in mind, the average yield for a savings account was still .08 percent as of March 2020), your investment would only yield $1,161 after 10 years. While you would miss the sometimes scary ups and downs in the market, you’d also miss the opportunity to earn a higher overall return.

When growth rates are volatile and inconsistent from year to year, understanding the CAGR can help smooth the returns so you can see the growth of an investment over time. That knowledge can help you compare investments and make more informed decisions.

Understanding the CAGR of an investment also shows that investing in the market works best as a long-term strategy. When you invest for the long term, rather than buying and selling frequently in an effort to time the market and take advantage of the highs and avoid the lows, you aren’t just attempting the impossible. You also miss out on the compounding effects that can increase your earnings.

Instead of viewing an investment through a short-term window that will show the latest jerks and jitters of the market, try viewing it through the CAGR. That measurement will reflect the investment’s growth over the long haul. And the stock market’s overall trend has been upward with significant growth over time.