Investopedia explains Compound Annual Growth Rate - CAGR
What Does Compound Annual Growth Rate - CAGR Mean?
The year-over-year growth rate of an investment over a specified period of time.
The compound annual growth rate is calculated by taking the nth root of the total percentage growth rate, where n is the number of years in the period being considered.
CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns.
Don't worry if this concept is still fuzzy to you - CAGR is one of those terms best defined by example. Suppose you invested $10,000 in a portfolio on Jan 1, 2005. Let's say by Jan 1, 2006, your portfolio had grown to $13,000, then $14,000 by 2007, and finally ended up at $19,500 by 2008.
Your CAGR would be the ratio of your ending value to beginning value ($19,500 / $10,000 = 1.95) raised to the power of 1/3 (since 1/# of years = 1/3), then subtracting 1 from the resulting number:
1.95 raised to 1/3 power = 1.2493. (This could be written as 1.95^0.3333).
1.2493 - 1 = 0.2493
Another way of writing 0.2493 is 24.93%.
Thus, your CAGR for your three-year investment is equal to 24.93%, representing the smoothed annualized gain you earned over your investment time horizon
Here is Excel formula that I am using CAGR=POWER(G13/G10,1/(ROUND(E8/365,1)))-1. (Email me if you wish to have the Excel spreadsheet.)
Now that you have know your CAGR of your investing/trading portfolio and the knowledge of the Secret of Compounding Effect, and you will have to constantly review your investing/trading strategies and refine them if necessary for you to reach your Final Investment Goals or Objectives.
From the above table, your CAGR come from 2 components:
1) Realized P/L
2) UnRealized P/L
To increase your CAGR, you have to increase your Realized P/L or UnRealized P/L or both and you have to deploy your available cash timely in the market. Too much cash at the sideline may not be helpful.
To increase your Realized P/L
Classic textbook's recommendation for Reward/Risk ratio of 2-3 for taking an investment is a good return.
I use CPF Ordinary Rate of 2.5% per annum as benchmark, I aim for at least an average of 5% ROC which is at least 2 x Reward/Risk ratio.
I have set for myself Yearly Target which is then translated to average monthly target as milestones towards the Final Investment Goal. We have to be realistic in the Stock Market as there is going to be some bad months that are below target.
For UnRealized P/L, you are just trying to outguess the Market forces to grow it and you have absolutely no control over it. The Market will determine your Exit Price when you need to cash them out unless you have no intention to sell your shares during your lifetime then it is not a matter of concerns.
My strategy is to keep growing the size of Realized P/L, which is then translated to MORE cash available to buy MORE Quantity of shares, and over time, hopefully to let the Magic Of Compounding work its way for me.
For example:
You bought 10 lots of Stock A @ $1.00 for $10K and then subsequently sold 10 lots @ $1.20 for $12K, and not considering brokerage fees just for a simple illustration.
When the Stock A pulls back to $1.1, you could buy back 10 lots of Stock A @ $1.1 for $11K. Now, you still have the same quantity of stock as before but with extra cash available ($1K) to to buy more shares and let the Magic of Compounding works its way through.
So have you started to measure your CAGR?
Posts
