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Compound Growth Rate

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The compound growth rate measures average growth of an amount over time. In other words, the compound growth rate assumes a constant rate of growth, thus smoothing the expansion rate. The advantage of the compound growth rate is that it expresses growth as one number. The downside of the compound growth rate is that it can hide sharp growth fluctuations. For example, suppose an investor buys stock that costs $3,000 at the start of year 1, declines in value to $1,000 in year 2, and appreciates to $4,000 at the end of year 3. The formula for the compound growth rate is ((Ending Value) /(Beginning Value))^(1/Number of years)-1. The compound growth rate would therefore be ((4,000) /(3,000))^(1/3) -1, or about 10%. The compound growth rate thus usefully shows average growth, but ignores the sharp drop in value during year 2.



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