Compound annual growth rate (CAGR) is the mean annual growth of an investment over a period of time exceeding one year. In simple terms, it is the annual return earned on your investments during a given period of time. It is one of the most accurate measures of determining the increase or decrease of returns over a particular period.
In the following paragraphs, we will look deeper into the concept of CAGR and how it can be useful in making informed investment decisions.
What is CAGR?
Compound annual growth rate or CAGR is the annual growth rate of an investment or business over a particular period of time. It includes the effect of compounding, which is the additional returns earned on your earnings.
For example, assume that you invest INR 10,000 in a mutual fund scheme and it grows at a CAGR of 10% over a period of five years. This means the average growth of your investment is 10% per annum. However, the actual rate may vary from one year to another wherein your capital may grow by 7% in the first year, 11% in the second year and so on. CAGR smoothens out the annual fluctuations and presents a consistent growth rate that can be used for comparison.
CAGR Formula
CAGR = (Closing Balance/Starting Balance)1/n – 1
Wherein
Closing Balance = Investment value at the end of the investment period
Starting Balance = Investment value at the onset of the investment period
n = Number of years of your investments
How does CAGR work?
The following example can help us better understand how CAGR works.
Consider you invested ₹1,00,000 in a mutual fund 7 years ago. Currently, your investment value is ₹2,00,000. So, you could say the value of your investment has doubled in terms of absolute returns. However, the absolute returns don’t tell you at what rate your investment grew in these 7 years.
Now, let's find the CAGR for your investments.
Closing Balance = ₹ 2,00,000
Beginning Balance= ₹1,00,000
Number of Years = 7
Therefore, CAGR = {(2,00,000/1,00,000)1/7 -1} x 100 = 10.40
Based on the above example, it can be said that your investment grew at an annual average of 10.40% over the last seven years.
(The example is for illustration purpose only)
Why is CAGR useful to you?
Most people consider absolute returns. For example, assume you invest INR 10,000 in a mutual fund scheme. At the end of three years, the investment value increases to INR 18,500. In absolute terms, the return on your investment is 85% over a period of three years, which means your capital is almost double during this time. However, this may not be accurate and it does not show the annual capital appreciation and this is where CAGR is useful.
CAGR = (18500/10000)1/3 – 1
i.e. CAGR is 22.76%
In other words, your investment earns an average annual return of approximately 23% over a period of three years. CAGR primarily shows the compounded annual returns irrespective of the year-on-year performance of the investment.
Returns are not same and your investment may deliver higher returns while in another year, the returns may be lower. It is also possible that in some years, the investment may deliver negative returns.
CAGR calculates the average annual returns earned on the investments. It is not a true return but a representation of how much the investment has grown if the returns were the same in each year during the investment period.
Uses of CAGR
Comparison of performance
CAGR is a standardized measure to compare the performance of various investments over a period of time. You can evaluate the investments by considering annual returns instead of absolute returns.
Long-term planning
This measure is useful for long-term investment planning as it assesses the potential capital growth over a period of time. You can use CAGR to evaluate the future value of your investments and make informed decisions based on the expected returns.
Risk assessment
CAGR assesses the possible investment risks. If the CAGR of a particular fund is consistently positive, it shows a reliable and stable growth, which is an attractive option if you are averse to high risks.
How CAGR is useful in mutual fund investments?
You can use the CAGR in a mutual fund in many ways to aid your investment decisions.
Fund’s Performance
The stock market usually acts volatilely in the short term, which also reflects on the returns of equity mutual funds. As a result, a good and reputed mutual fund can also show unsatisfactory returns if the markets are currently volatile.
In these circumstances, you can use the CAGR to know the average rate of returns the fund delivered over a period, say five years. This can help you make an informed investment decision depending on the fund’s performance over time.
Comparison Between Different Funds
CAGR is a useful tool to compare the returns of a particular fund against other funds that use similar benchmarks. For example, you can compare the 5-year CAGR of a small-cap mutual fund with that of other small-cap funds to know whether the fund underperformed or delivered outstanding returns.
Limitations of CAGR
While CAGR is a crucial parameter to identify the annual growth of your investments, it has some limitations.
No Indicator of Future Performance
CAGR is suitable for assessing a fund’s past performances, but it doesn’t indicate conclusively how the fund will perform in the future.
For instance, just because a fund has delivered returns at 10 % CAGR in the past three years doesn’t mean that it will continue to deliver returns at similar rates in the future. It may provide higher or lower returns based on the markets and other factors like portfolio type, exposure to certain sectors, etc. Therefore, investors should not evaluate a mutual fund based solely on its CAGR. It is essential to evaluate it against other parameters as well to make an informed investment decision.
Only Works on Lump Sum Investments
The CAGR formula only considers the investments made at the beginning and the final amount at the time of closing the investment. It doesn’t consider perioding investments like Systematic Investment Plans (SIPs).
Doesn’t Consider IDCW Payouts
Some mutual funds pay IDCW (Income distribution cum capital withdrawal) as per the management’s decision. CAGR doesn’t consider IDCW payouts by default. However, you can manually include the IDCW payouts by adding them to the closing balance of your investment.
Not a Complete Risk Assessment Tool
A CAGR alone can’t help you assess the investment risks in a mutual fund. You need to consider various parameters like the fund manager’s track record, the fund house’s reputation, the mutual fund type, etc., to assess the risks involved in investing in that fund.
CAGR is a valuable tool to assess the overall consistency of a mutual fund over a certain time frame. However, you should use it along with other factors to identify the right investment option for you.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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