CAGR – What Is It And Why Is It Relevant For Trading Strategies? (Performance Analysis)
What is CAGR?
CAGR is an abbreviation of Compound Annual Growth Rate, and is a common measure of growth that is used to measure the returns on investments over several time periods on an annual basis. It can be used on a range of securities such as mutual funds, shares or bonds but is also used outside the world of trading and investments to track the development of metrics such as customer satisfaction. Unlike many other metrics such as Absolute Return, CAGR accounts for compound interest, meaning that it often produces more accurate results that to some extent take into account the erratic and volatile development of investments.
How to Calculate CAGR
As we’ve mentioned, CAGR is different from many other return metrics in that it takes into account the compounding of the investment. Therefore, the formula is a little more complicated than Absolute range, or average yearly return.
To calculate CAGR you need three values
- The beginning value
- The ending value
- Number of years
CAGR is calculated by dividing the ending value by the beginning value, and then raising that figure to one divided by the number of years in the period. Once this calculation is done, you need to subtract one from the results to get the CAGR of the investment.
Here follows the formula:
(Ending value/Beginning value)^(1/number of years) -1
Example Case
Let’s say that we have an investment that we invested $1000 dollars in. The following four years it fluctuated as follows:
To calculate the CAGR of this investment during the four year period shown in the table, we first need to find the beginning and end values. Since we started with $1000 and ended with $1250, $1000 will be our beginning value and $1250 our ending value. The number of years in the investment is 4 years. When putting those values into the formula, we get the following:
(1250/1000)^(1/4) – 1 = 0.057
In other words, the CAGR of our investment was 5,7%.
Real-world Case: CAGR of S&P 500
The S&P 500 is one of the most well-known indexes, so why not calculate the CAGR of the S&P 500! Our calculation will be done under the assumption that dividends are reinvested, and that the expense ratio is zero, which actually is the case with some index funds (read our article on index funds to find out more).
We’ll calculate the CAGR in the years from 1871 to 2019. We’ll assume that $1 dollar was invested in 1871.
148 years later, in 2019, that $1 would have grown to $372, 500!
In other words, we have our beginning value ($100), our ending value ($372, 500), and the number of years (148 years). Let’s put these values into the CAGR