Compound annual growth rate, or CAGR, is a term that gets used when investment advisors tout their market savvy and funds promote their returns. But what does it really show?

The CAGR is a mathematical formula that provides a “smoothed” rate of return. It is really a pro forma number that tells you what an investment yields on an annually compounded basis; it indicates to investors what they really have at the end of the investment period.

The Good

CAGR is the best formula for evaluating how different investments have performed over time. Investors can compare the CAGR in order to evaluate how well one stock performed against other stocks in a peer group or against a market index. The CAGR can also be used to compare the historical returns of stocks to bonds or a savings account.

The Bad

When using the CAGR, it is important to remember two things: the CAGR does not reflect investment risk, and you must use the same time periods.

Investment returns are volatile, meaning they can vary significantly from one year to another, and CAGR does not reflect volatility. CAGR is a pro forma number that provides a “smoothed” annual yield, so it can give the illusion that there is a steady growth rate even when the value of the underlying investment can vary significantly. This volatility, or investment risk, is important to consider when making investment decisions.

The Ugly

Things get ugly when the CAGR is used to promote investment results without incorporating the risk factor. Mutual fund companies emphasize their CAGRs from different time periods in order to get you to invest in their funds, but they rarely incorporate a risk adjustment. It is also important to read the fine print in order to know what time period is being used. Ads can tout a fund’s 20% CAGR in bold type, but the time period used may be from the peak of the last bubble, which has no bearing on the most recent performance.

Conclusion

The CAGR is a good and valuable tool to evaluate investment options, but it does not tell the whole story. Investors can analyze investment alternatives by comparing their CAGRs from identical time periods. Investors, however, also need to evaluate the relative investment risk. This requires the use of another measure such as standard deviation.