What is CAGR?
CAGR smooths out the volatility of year-to-year returns into a single annualized figure. If $10,000 grows to $19,672 over 10 years, the CAGR is 7.0% - even though actual annual returns varied widely. The formula is (Ending Value / Beginning Value)^(1/Years) - 1. CAGR is the most honest way to report long-term investment performance.
CAGR vs. Average Return
Average return can be misleading. If an investment gains 100% one year and loses 50% the next, the average return is 25% but the CAGR is 0% - you are back where you started. The S&P 500's CAGR from 1926 to 2023 is approximately 10.3%, while the arithmetic average annual return is about 12.1%. The gap reflects the drag of volatility.
Key Considerations
CAGR does not reveal the path taken - two investments can have identical CAGRs but very different volatility profiles. It also assumes all gains are reinvested. When evaluating fund performance, always ask for CAGR rather than average returns, and consider the maximum drawdown alongside CAGR to understand the full risk-return picture.