The Compound Annual Growth Rate (CAGR) is an important measure of investment performance and financial goal setting. With more and more investors using CAGR calculators to make informed investment decisions, it is important to know how to use them properly. This article discusses the most frequent errors investors commit when using CAGR calculators and how to avoid them.
Common mistakes when using CAGR calculators
Here is a list of common mistakes you can make while using a CAGR calculator.
- Omitting the period
One of the most common mistakes is failing to consider the time for which the CAGR is computed. The compound annual growth rate is very sensitive to the length of the investment, and applying an unsuitable time frame can result in inaccurate outcomes.
- Forgetting dividend distributions
Another frequent mistake is not including dividends or distributions. If you are investing in stocks or mutual funds that pay dividends on a regular basis, leaving these payments out of your calculations will underestimate the actual return on your investment.
- Misinterpreting CAGR as actual year-over-year returns
The compound annual growth rate is an average smoothed rate of growth over time and not the actual return in each specific year. An error is the assumption that the investment increases by the CAGR percentage every year, which practically is a rare-case scenario.
- Ignores changes in investment
Omitting to factor in the change in the amount of investment over the timeline under consideration is another common error. Contributing money during the investment period will increase the CAGR, and withdrawing money will decrease it.
- Not accounting for fees and expenses
Most investors make errors while calculating CAGR on a gross return, ignoring the effects of fees, taxes, and other costs. This can cause the actual return received to be overstated.
- Projecting CAGR into the future
Projecting that an investment will continue to increase at its past CAGR in perpetuity is an error that many investors make. Projecting the current CAGR into the future can create unrealistic expectations and suboptimal investment choices.
How to avoid these errors
With these steps, you can skip the errors:
- Select a suitable timeline
Pick an appropriate interval of time which properly represents your investment time horizon. For long-term targets, try using three-to-five-year intervals for worthwhile results.
- Consider all the relevant cash flows
Justify dividends, distributions, extra contributions, and withdrawals from the amount to calculate the final CAGR. Make use of advanced calculators that support these adjustments.
- Comprehend what CAGR signifies
Keep in mind that CAGR is a smoothed standard and doesn’t reflect actual annual returns. Use it as one of a variety of evaluation measures.
- Account net returns
Compute CAGR from net return after fees, taxes, and expenses for a better picture of actual performance.
- Use more than one metric
Use CAGR in conjunction with other financial measures such as internal rate of return (IRR) and standard deviation to achieve a clear picture of investment performance.
Conclusion
With more investment instruments and financial uncertainties, sound financial measures matter more than ever. By avoiding these familiar errors when calculating CAGR, investors can invest wiser and judge the real performance of their investments more accurately. Keep in mind that although CAGR is a good tool, it must be combined with other tools and the guidance of professionals to do full-fledged financial planning.