Dr. Harvey's Financial Glossary

Thursday, May 22, 2008

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Compound Annual Growth Rate: Annual return calculated based on each year's previous balances where each previous balance includes both the original principal and all interest accrued from prior years. Best defined by example. If you invest $100 today and make 5% in the first year and reinvest ($105) and make 8% in the second year, the compound_annual_return growth_rates is 6.489%. The calculation is $100x1.05x1.08=$113.4 which is what you end up with at the end of year two. The average_rate_of_return is [square root(113.4/100) -1]= 0.06489 or 6.489%. Note 1. If we had three compounding periods we would take the cubic root (power of 1/3). Note 2. If we had invested at exactly 6.489 in both periods, we get $100x1.06489x1.06489=$113.4. Note 3. The example is directed to a return- but CAGR could be applied to earnings growth, GDP growth, etc.

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