CAGR stands for compound annual growth rate.
The first thing to remember when it comes to a CAGR is that it’s just a mathematical equation used to understand roughly how much an amount is growing per year. So this can be applied to anything from a savings account, to one’s holdings in an investment fund, to a company’s revenue or earnings growth rate.
So let’s get into how a CAGR works and what it tells us.
Let’s say someone puts $2,000 into a stock fund and the fund grows to $3,200 in 7 years. That’s a return of 60% for the total time period.
But what was the annual rate of return? That’s something we want to know if we are to recommend this fund to someone else. We could just find the performance each year for all 7 years, but that rate of return will vary -- maybe there were a few down years and a few great years. And taking the average of those annual rates of return won’t tell us enough either.
So let’s look at the stock fund that started with $2,000 in year one. Using a CAGR calculator, which is easily accessible online, we get a result of 6.94% for the compound annual growth rate.
So let’s say a person knows he or she needs $10,000 to buy a home in 10 years and is starting with $5,000, that person needs his or her investments to compound at an annual rate of 7.18%.
It’s great -- with this little formula, you can plan your life goals with much more ease and comfort. But remember -- a CAGR is like a simplified version of a market return, but volatility can always undermine these return projections. And as an investor, you should always plan for volatility.