What is CAGR?
Any investment that provides you with the advantage of compounding can assist you to build and double your wealth. Compound Annual Growth Rate CAGR demonstrates the growth of an individual’s investment over a specific period.
Specifically, it is the average returns an investor has earned on his investments after a said period say one year. Banks and financial institutions calculate this rate in terms of a percentage.
A constant rate of return cannot be provided by a single stock or a mutual fund year on year, since the rate may change. Additionally, if you make many investments, you need to know the consolidated returns earned on all the investments.
For instance, say you have invested in a specific mutual fund for a tenure of five years. CAGR will highlight how much returns you have earned from that fund for every year during that period, though this is applicable only if the gains are re-invested every year.
What is Compound Annual Growth Rate
Most of the times, investors depend on absolute returns to determine the performance of their investments but, the time value of money is ignored.
On the other hand, CAGR considers the period for which the investor has stayed invested in the given opportunity. CAGR gives you an approximate rate at which your investment could grow if there is no market volatility involved. It is the most suitable calculation to even out the fluctuations experienced by the said asset over a specific time.
CAGR is one of the best means to gauge, how an investment has performed compared to its price over the particular time horizon.
There are three easy steps to calculate the CAGR using these three values:
1. The investment made in the initial year – beginning value.
2. Value of investment at the end of the year – year-end value.
3. Tenure of investment – number of the years (s).
The formula for CAGR is :
However, to better understand this formula let us look at this example.
Purchase of Stock for Rs. 100 in 2015, Rs. 125 in 2016, Rs. 150 in 2017
If we put these values in the formula above, the CAGR for the investments between 2015 and 2017 is 22.47%.
What is CAGR in Mutual Fund?
In the case of mutual funds, the investor should know whether the investment will be worth it or not for that specified time. For this, the investor requires a means to measure mutual fund performance over a given period.
The mutual fund fact sheet provides the growth rates across the different investment time frames for the fund. However, these multiple rates could confuse the decision of the investor to make his final decision.
Alternatively, it would be simpler to see the annual growth of the fund in a glance. This is where CAGR will assist you with a single yearly growth rate. Additionally, it also puts the concept of compound interest into perspective.
Most of the mutual funds and other investment options use compound interest to compute their returns. Therefore, CAGR is an apt way to quantify the performance of the fund.
The actual CAGR meaning – what investors should know
• It is one of the most accurate methods to calculate and decide the returns for any investment or business that has a value that can rise or fall over time.
• CAGR is not a guide to sales which have been completed from the beginning year to the end year. At times, the growth may be either concentrated in the initial or toward the end of the year.
• CAGR does not reflect the investment risk.
• At times, the same CAGR may be reflected for two investments, with one being additionally lucrative than the other. This could happen because the growth of the investment was quicker in the initial year for one, whereas the growth for the other only took place in the last year.
• CAGR can be used to compare two alternative investment options to assess how well one stock performed against the other stock in a peer category or the market index.
• CAGR is usually employed for investment periods ranging from 3 to 7 years. If it is more than 10 years, then the CAGR might obscure the sub-trends in between.
• Concerning investments, the CAGR is a different one year on year.
In short, CAGR full form which is the Compound Annual Growth Rate is far more consistent to track the growth of investments as compared to other methods. Another calculation known as the annual rate of return doesn’t consider the compounding factor which leads to overestimation. Therefore, it is useful to understand how investments grow in terms of CAGR and utilize it to compare various funds.