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The compound annual growth rate (CAGR), is a definition that is used when investment advisers tout their market savvy as well as funds to promote their returns. Now we shall see what the CAGR will show and discuss the positive and negative side of the term. 

Well CAGR is basically a mathematical formula that is used to provide a smoothed rate of return. The formula will indicate to the investors the exact amount that they will really have at the end of the investment period. CAGR will also tell you what an investment will yield on an annually compounded basis as it is a pro forma number. So let’s take an example and assume that you have invested RM1000 at the beginning of 1999 and at the end of the year your initial investment has increased to RM3000 which is a 200% return. By year 2000 the market dipped and you lost 50% of your investment which left you with RM1500 at the end of the year. So after the two years you may be wondering the return on your investment for that particular period. In this situation using the average annual return does not work, so the average annual return rate on this particular investment was 75% which is calculated from the 50% loss and the 200% gain. However after the two year period you have ended up with RM1500 instead of the RM3065 which is the RM1000 for the two years at an annual rate of 75%. So with the formula of the CAGR, you can calculate the annual return rate for those particular periods.

And you can the calculation of the CAGR by taking the nth root of your total return of your investment where the n is the number of years you have held the investment. For this particular example you can take the square root of 50% as the total number of years for your investment was two years, where your CAGR is 22.5%.

The good thing about the CAGR is that it is the best formula that can used to evaluate the performance of the different investments over a certain amount of time. This is where the investors can utilize the CAGR so that they can compare it with one another in order to evaluate on how well one particular stock has performed against other stocks wither from a market index or from a peer group. This CAGR can also be used to compare the historical returns of a savings accounts as well as stocks to bonds.

However two things that investors need to remember when using the CAGR is that you must use the same time periods and the CAGR does not reflect the risk of the investments. CAGR is a form of calculation that does not reflect volatility and one thing about investment returns are that they are volatile, which means that the numbers can vary greatly from one year to the next. Like stated previously the CAGR is a pro forma that will provide a smoothed annual yield, this is effect will give off the illusion that there is a steady growth rate despite the fact that the underlying investment can vary significantly. As with all decision making when it comes to making an investment the investment risk and volatility of the stocks that they are interested in should be taken into consideration. Depending on the time frame the results of the investment can vary significantly.

Things will turn out for the worse when the CAGR is used to promote the investment results without incorporating the risk factor. This goes for the mutual fund companies as well because they will emphasize the CAGR from different time periods so that they can get people to invest in the funds of the company and they rarely incorporate a risk adjustment. When looking at the information about certain stocks that you are interested in can tout a fund’s 20% CAGR in large print; however the time period used may be different and was actually the peak from the last bubble. This type of misinformation has no actual bearing on the most recent performance so it would be wise to read the fine print to know the actual period that was used in the report.

So all in all investors need to remember that the CAGR is a useful and valuable tool to evaluate the options for investment, but it does not tell the entire story. The comparison of the CAGR from the same time frame can be used to analyze the investment alternatives. What the CAGR do not tell is the relative investment risk and another form of measurement is required such as the standard deviation.

Standard deviation can be defined as the statistic that is used to measure the annual returns which may vary between the expected returns. So this means the larger standard deviation can be found in very volatile investments due to their annual returns being significantly different from that of their average annual return. This is in direct comparison with that of the smaller standard deviation in less volatile stocks, due to the average annual return being closer to their annual returns. To put it into perspective, the standard deviation of a savings account is zero as the annual rate has the expected return with the assumption that the investors do not deposit or withdraw any money from that account. This is of course different from that of stock prices that can differ greatly from its average returns which would then cause a higher standard deviation. So to summarize it all, the standard deviation of a stock is usually greater than that of a bond that is held to its maturity or a savings account.