The compound annual growth rate (CAGR) is a useful measure that calculates the mean annual growth rate of an investment over a specified time period longer than one year. Unlike simple annual growth rates, which can only measure the difference between the start and end points, CAGR provides a smoothed annual rate that essentially flattens out the rate of growth as if it were steady over the specified period. It therefore represents one of the most accurate ways to understand and compare the returns on various investments over time because it takes into account the effect of compounding.
CAGR is significant for investors as it offers a clear, comparable picture of investment performance. Whether evaluating the growth of stock prices, investment portfolios or the revenue of a business over several years, CAGR helps to standardise returns for easy comparison. It mitigates the effect of volatility of periodic returns, providing a cleaner insight into the real rate of return on an investment. For example, if an investment grows from £1,000 to £2,000 over five years, the CAGR would calculate the rate at which the investment would have grown each year if it had grown at a steady rate.
However, while CAGR is a powerful tool for understanding and comparing investment growth, it does not account for the risk or volatility of the investment. Two investments might have the same CAGR but vastly different levels of risk. Therefore, investors should use CAGR as one of several metrics in their evaluation process, considering it alongside measures of risk, volatility and other factors that could affect investment returns. CAGR offers a simplified, annualised picture of growth, but a comprehensive investment analysis requires a broader view of performance and risk.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.