When you look at the returns offered by a mutual fund scheme or any investment you make, you would often come across the word CAGR as a measure of the value of your earnings. Have you ever wondered what actually is CAGR meaning and how it is calculated? What is its relevance to the investment universe? Let’s deep-dive.

This article covers: 

What is CAGR?

The CAGR meaning, in simple terms, is the average annual return yielded by an investment over a given period of time. The important point here is that it is an average of the returns. Your investment may yield different returns over different periods, reacting to market fluctuations and movements. There may be times when your investment, let’s say in stocks, may even give you negative returns during market slumps, but may make you very happy with the performance during bull markets. How do you assess if the investment is actually benefiting your portfolio or not? Herein lies the significance of CAGR.

What CAGR does is that it smoothens out the returns over the specific period of your assessment to help you understand the worth of the investment. 

For example, if a mutual fund scheme is launched with a NAV of Rs 10 and, after a year the NAV becomes Rs 12, the return offered by the scheme is 20%. Now, in the second year, if the NAV grows to Rs 14, while in absolute terms, your NAV has risen by Rs 2 just like in the previous period, but the return would be 16.66% here. The CAGR gives the compounded annual rate of return on the investment and smoothes out the differentiated yield rates. 

How is CAGR calculated?

The formula for calculating CAGR is as follows:

CAGR = [{(End value / Starting value) ^ 1/N} – 1] * 100

‘N’ in the above formula is the number of years over which the value has grown.

If you put the CAGR formula in the above-mentioned example, the CAGR would be calculated as follows:

End valueRs 14
Starting valueRs 10
Time period2 yrs
CAGR [(14/10) ^ ½ – 1] * 100= 18.32%

So, though the interest rates in the first and second years were different, the CAGR gives the average annualized rate of 18.32% and helps you assess the average returns earned by the investment.

Uses of CAGR

CAGR is an extremely useful tool in assessing the return-yielding potential of market-linked investment avenues, whose returns vary due to market volatility. Here are some of the uses of CAGR:

Comparing unrelated investment avenues

When you have a limited amount to invest, you often wonder which avenue would give the best returns on your investments. CAGR can come to your aid here. CAGR gives you the annualized returns of different avenues, unrelated to each other. Thus, by checking the CAGR of different instruments you can pick one which has given the best returns and choose to invest in it if it meets your risk profile.

Comparing mutual fund schemes

When comparing similar mutual fund schemes, checking their past returns gives you an idea of how the scheme has performed over the years. Comparing across different time periods may give you different figures to work with that may be confusing. CAGR helps you narrow down your results so that you can check the historic returns of the scheme and consider investing in one which has given the highest returns. 

For making investment decisions

The CAGR formula can be used in two additional ways. If you need a specific corpus for a financial goal, you can use the CAGR formula to find out the minimum rate of return that you need to earn on your investment to create the desired corpus.

For example, say you have Rs 5 lakh to invest and you need a corpus of Rs 50 lakh after 10 yrs for funding the college education of your child. You can use the CAGR formula to find the rate of return which is a must on your investment of Rs 5 lakh to grow to Rs 50 lakh in 10 yrs. If you put the values in the CAGR formula, the rate could be calculated as follows:

Rate of return = [{(50 lakh / 5 lakh) ^ 1/10} – 1] * 100

= 25.89%

So, you need an avenue that gives a minimum annualized return of 25.89% to grow the corpus amount to Rs 50 lakh.

Alternatively, if you know the rate of return and the required corpus, you can find out how much investment would be needed to attain the corpus after a specified time period. So, in the above example, if the rate of return is 25.89%, the corpus is Rs 50 lakh and the time period is 10 yrs, you can back-calculate to find the required investment amount to be Rs 5 lakh.

Compound Annual Growth Rate gives you the annualized returns of different avenues, unrelated to each other. Click To Tweet

Limitations of CAGR

Though CAGR is useful in selecting an investment scheme, it has its limitations. These limitations include:

CAGR smoothens out the volatility risks associated with investments. Some years, the markets might give negative returns but when the returns are averaged out, this volatility is not highlighted and you don’t get the true picture of the y-o-y returns.

In the case of periodic investments and withdrawals from the scheme, CAGR might not give the right rate of return since it does not account for inflows and outflows. It is, thus, suitable for assessing returns on a lump sum investment.

CAGR does not give the risk-adjusted returns from equity investments, which is crucial in determining whether the investment is suitable at a given risk level or not.

To assess the suitability of investments, you need to understand what is CAGR. When you know what CAGR means and how it works, you can compare and pick the right investment avenues. However, do remember the limitations that are inherent to CAGR and keep them in mind when using the parameter to judge between different investments. Be an informed investor and invest in different schemes offering the best returns on your investment. 

Manonmayi

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