It's all about returns over time. How they grow. Compound. Grow up. Get Bar Mitzvah'd or Quinceanera'd. And then get married, and then triple in size from either pregnancy or depression.
Um...yeah. So the average annual return is a common measure for mutual funds, but calculating the compound annual growth rate (CAGR) is even better. Assuming the investment is really compounding over a certain period of time, you can assess the growth rate from when you made the first investment until the present time.
The reason the CAGR presents a truer picture is that the average annual return does not take into account compounding, so it can overestimate the growth of an investment. The CAGR is an average that calculates the rate at which the investment would have grown if it had compounded at the same rate each year.
The formula for CAGR is:
CAGR = (Ending Value / Beginning Value)1 / n - 1
...where n is the number of periods in months or years.
You invest $2,000 in the We Always Compound fund for five years. Here is the value of your investment at the end of each year:
Year Ending Value
1 $1,500
2 $2,000
3 $6,000
4 $8,000
5 $10,000
You can calculate the CAGR of the investment as:
CAGR = (10,000 / 2,000)1/5 - 1 = .37973 = 37.97%
And yeah, this'll be a lot easier if you use a financial calculator, or Excel.
If you had simply taken an average of the returns from year one (-25%) and two (33%) it would come out to a positive 4%. But actually, the growth was 0%, since you ended up with the same $2,000 you started with.
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Finance: What is Compounding Value or Co...1773 Views
Finance allah shmoop What is calm Pounding value or compounding
interest Ah the power of compounding it makes tree's stronger
pollution More feral and the rich Well richer How so
Well let's start with compounds kissing cousin with six toes
Arithmetic calm pounding Right So the first was really geometric
compounding Now we're talking about arithmetic compounding If you invest
a thousand bucks in a ten year bond that pay
six percent a year in interest the dough comes back
to you in a pattern that looks like this Like
every six months they pay thirty bucks and it's sixty
dollars a year Got it nice You get the total
of sixteen hundred bucks back from your investment And the
cash that came back to you you know came in
small parts all along the way until you got about
two thirds of it or sixty percent at the end
right If you just spent that money and collected your
thousand bucks at the end That's it Okay So that's
arithmetic compounding the money comes to you You don't reinvest
it Ding ding ding that's the key here and you
just go buy burgers Okay So now let's look at
what six percent compound id looks like over the same
ten year period Wealth at the end of your one
it's a thousand sixty bucks and no we're only going
to compound it annually We probably should do the semi
annually but we confuse you even more is we won't
do that but then you essentially re invest that money
and you get another six percent compounded on that thousand
sixty instead of six percent compounded against the original thousand
so by the end of your two you'll have a
thousand one hundred twenty three sixty and by the end
of your ten you'll have one thousand seven hundred ninety
dollars and eighty five cents So why do you make
so much more money when you compound interest versus getting
thirty bucks twice a year like you would in this
bond example going by and burgers with it You don't
wanna do that well essentially what's happening is that you're
delaying your gratification of getting that sweet sweet cash or
getting liquid Whatever you wanna call it by reinvesting your
gains year after year after year So do you have
that sort of self control Do you need the cash
Yeah that's The question If you for example have trouble
making it home from your local pizza spot with the
pie intact well and compound interest Keeping the discipline to
not spend the money today and wait for the happiness
tomorrow Well when that may not be for you Sorry
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