What is Compound Annual Growth Rate (CAGR)? Why it is extremely important to understand it properly?
In investment world, returns is a big deal. It probably gets more attention than almost any other metric out there, and occupies the largest mindshare among most investors.
As an investor, you should be aware of 2 commonly used metrics which are used to represent returns. They are CAGR & XIRR. In this episode, we are going to see about CAGR in detail.
Compound Annual Growth Rate (CAGR)
This is nothing but the compound interest formulae you have learnt in your 8th standard math. CAGR is used to represent point-to-point returns.
Say, you have invested 1L rupees in a mutual fund 5 years ago, If the current value of the investment is 2L rupees, then to calculate CAGR, you can use this formulae.
CAGR = 100 * ((Final_Amount/Initial_Amount)^(1/t)-1)
In this case, Final amount is 2L, Initial amount is 1L and time period t is 5 years. With that, let’s calculate CAGR.
CAGR = 100 * ((2L/1L)^(1/5)-1)
= 100*((2)^(1/5)-1)
=100*(1.1486–1)
=100*(0.1486)
=14.86%
So when it comes to mutual funds investing, you would have seen funds providing some % CAGR returns over a period of time. Say, a fund has given 15% returns over 5 year period, then it indicates it will double your money in 5 years. Remember, compounding is happening year on year in this case, that’s why you are seeing elevated returns.
But there is one another thing you need to remember here. All this represent point-to-point returns. So CAGR can be used to calculate returns on the lumpsum investment and one shot withdrawal.
Also, your returns can vary drastically even if we move the investment and withdrawal by one or two days as well if there is a price drop or rally on those specific days. So if you are someone who is investing in mutual funds through SIP, then predicting your returns through CAGR will be misleading and instead we should use XIRR.
For more details and examples, checkout: