How do you measure and project financial growth?
If you spend any time around financial blogs, influencers, etc you’ll inevitably see someone mention that some index, like the S&P 500, has returned an average of 10% a year since its inception. When you see something like that, what is your initial assumption? Does that mean you can just assume your money will grow at 10% year over year? Well, that depends, but it’s wise to understand what assumptions go into a statement like that.
1 – You should know what the S&P 500 actually is. It is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. This doesn’t include other types of investment assets, like bonds, treasuries or companies outside the US, or cash.
2 – You should know how your investments are actually invested. If they are tracking a smaller number of stocks or a different index entirely, it might be more volatile. If you have a portfolio that includes other investment types, like bonds, international stocks or cash, your rate of return might be higher or lower.
3 – What about inflation? Inflation is not counted in the Average Growth Rate, so depending on how much inflation is running, you may not be gaining actual purchase power. OnTrajectory allows you to turn on today’s dollars vs. tomorrow’s dollars so you can take inflation into account. For more information about inflation an the average return, see this article from NerdWallet.
4 – You should think about the timeframe. That average is true for the life of the index, but each year can be volatile. See this chart from Macrotrends: S&P 500 Historical Annual Returns. That means in any given year the S&P has fluctuated up and down significantly. So, if you need the money in your account soon, many people look at a mix of stocks, bonds and cash.
So, what about the Compounding Annual Growth Rate?
So what about Compounding Annual Growth Rate? This number is calculated from your specific portfolio and assumes that the money in the account is compounding, meaning that the money that is in the account grows and is reinvested in a similar manner to achieve similar results.
We asked Penny, our new AI guide, to explain the difference between the Compounding Annual Growth Rate and the Average rate of return. Here is the answer:
“Compounding Annual Growth Rate (CAGR) and Average Growth Rate are both used to measure the growth of an investment or asset over a specific period of time. However, they differ in the way they calculate and represent the growth. CAGR is a measure of the annualized growth rate of an investment over a specific period, assuming that the investment grows at a constant rate. It takes into account the compounding effect, which means that the returns from each year are reinvested and contribute to the overall growth. CAGR provides a more accurate representation of the investment’s performance over time, especially when the growth rate is not consistent. It is commonly used to compare the performance of different investments or to project future growth.
On the other hand, Average Growth Rate simply calculates the average rate of growth over a specific period by dividing the total growth by the number of years. It does not consider the compounding effect and assumes a linear growth rate. Average Growth Rate can be useful for understanding the overall trend of an investment but may not accurately reflect the actual growth experienced over time.”
So, in OnTrajectory, you can calculate your investment account’s CAGR and then, assuming you make similar investment decisions that you have made in the past, use that number to project forward. For instance, if your account has returned a compounding annual growth rate of 4%, it may be wise to use that number because it is tracking your actual returns.
Additionally, if you are using OnTrajectory to model your investments and you are an unlimited subscriber you can create multiple scenarios to compare different possibilities. This is especially helpful if you don’t think the next 5 years will be the same as the last 5 years. You can create a more optimistic or pessimistic scenario to see what might happen or use the stress test feature to run a simulation on some type of market drop.
If you want more information about how to use these features, just let us know by filling out this form and we will send you more details on how to get the most out of your OnTrajectory Unlimited Subscription!
OnTrajectory is financial modeling software, we do not offer investment advice and none of the information here should be considered advice. Contact a registered financial advisor for investment advice.