As an investor, gauging the actual performance of your investments is crucial for making informed decisions. However, calculating and comparing investment returns can often be perplexing, especially when dealing with diverse investment options and various time frames. That is where the concept of CAGR kicks in.
Let us understand every single aspect of CAGR in this post.
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CAGR stands for Compound Annual Growth Rate. It measures the average annual return of an investment over a certain period, assuming that the profits are reinvested at the end of each year. CAGR helps compare the performance of different investment options over the same time horizon, regardless of their initial value or volatility.
You can calculate CAGR manually using the following formula.
CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1
Let us consider an illustration to understand CAGR.
Suppose you invested Rs. 10,000 in a mutual fund in 2015 and Rs 15,000 in another in 2016. By the end of 2020, the first mutual fund was worth Rs. 18,000, and the second was worth Rs 25,000. Which mutual fund performed better over the five years?
If you look at the simple annual return, you might think that the second mutual fund was better because it had a higher return of 66.67% [(25,000 - 15,000) / 15,000] compared to the first mutual fund's return of 80% [(18,000 - 10,000) / 10,000].
However, this does not take into account the time value of money and the compounding effect of reinvesting profits.
If you use the CAGR formula, you will get a different result. Here is how
The CAGR of the first mutual fund is:
CAGR = (18,000 / 10,000) ^ (1 / 5) - 1
CAGR = 0.125 or 12.5%
The CAGR of the second mutual fund is:
CAGR = (25,000 / 15,000) ^ (1 / 4) - 1
CAGR = 0.136 or 13.6%
As you can see, the second mutual fund actually had a higher CAGR than the first one. It means that it grew faster on an annual basis over four years. This shows that CAGR is a more accurate and consistent way of measuring returns than simple yearly returns.
If you find manual calculation tedious, you can utilise an online tool known as the CAGR calculator.
To use this tool, you need to enter three inputs:
Once you input the required variables, the calculator will then display the CAGR percentage and a bar chart showing the growth of your investment over time.
For example, if you want to calculate the CAGR of an investment that started at Rs 20,000 in 2017 and ended at Rs 35,000 in 2020, you would enter these values in the calculator:
- Beginning value: Rs. 20,000
- Ending value: Rs. 35,000
- Number of years: 3
The calculator will then show you that the CAGR of this investment is 20.2%. The calculator also displays the bar chart showing you how your investment grew from 2017 to 2020.
CAGR also has some drawbacks that limit its accuracy and applicability. These limitations include:
CAGR is a powerful and straightforward way of measuring the average annual return of an investment over a certain period. You can use it to compare different investments, assets, and industries' performance over the same time horizon and account for compounding effects. You can use CAGR to evaluate your past performance and plan your future goals. But before you rely entirely on this approach, make sure you are considering the downsides of the CAGR we have discussed above.
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