When it comes to evaluating the performance of your investments, two key metrics often arise: Compound Annual Growth Rate (CAGR) and Arithmetic Average Return (AAR). While both measure the growth of your investments over a specific period, they do so in different ways. Understanding the difference between CAGR and AAR can significantly impact your investment decisions.
What is CAGR?
CAGR, or Compound Annual Growth Rate, represents the annualized rate of return of an investment over a specific period. It assumes that the investment’s returns are reinvested at the end of each period, allowing the initial investment to grow exponentially.
What is AAR?
AAR, or Arithmetic Average Return, is a simple average of an investment’s annual returns over a specific period. It doesn’t account for the compounding effect of returns, which can be significant over longer time horizons.
Why the Difference Matters
While AAR provides a straightforward measure of past performance, CAGR offers a more accurate representation of an investment’s true growth. This is because CAGR considers the compounding effect of returns, which can significantly impact an investment’s overall growth over time.
Example:
Let’s say you invested $10,000 in a stock portfolio five years ago. The value of your portfolio at the end of each year is as follows:
Year Value
1 $11,000
2 $10,000
3 $12,000
4 $13,000
5 $15,000
Calculating AAR:
- Annual returns: 10%, -10%, 20%, 8.33%, 15.38%
- Sum of annual returns: 44.71%
- AAR: 44.71% / 5 = 8.94%
Calculating CAGR:
- BV = $10,000
- EV = $15,000
- n = 5 years
- CAGR = (15,000/10,000)^(1/5) – 1 = 8.45%
As you can see, the CAGR (8.45%) is slightly lower than the AAR (8.94%). This is because the AAR doesn’t account for the compounding effect of returns. In this case, the compounding effect slightly reduces the overall growth rate.
When evaluating investment performance, it’s crucial to consider both CAGR and AAR and other factors such as risk and volatility. CAGR is a more accurate measure of investment performance over longer periods. AAR is a simpler metric but may not fully capture the impact of compounding. You can better assess the performance of your investments and make informed decisions to achieve your long-term financial goals by working with experienced financial planners.
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