If you see various websites which track the performance of Mutual Funds or Stocks, you would have seen this term thrown around – CAGR. CAGR stands for Compounded Annual Growth Rate. CAGR is a very useful concept to understand how much your investment has grown on an annually compounded basis.
It is very useful to compare two or more investments which might have different capital and different time frames. Using the normal formula of Return gives you only the absolute rate of return.
If you bought a house for Rs.50 lakhs and after couple of years you sold it for Rs.55 lakhs, you made a return of 10%. But remember that this is the absolute return. If I asked you how much return you got annually, do you know it? No! It is not 10% divided by number of years = 5%. Remember your returns compound every year.
If I say that in the mean time I invested Rs. 50,000 in some stock and after 3 years I sold it for Rs.60,000. Now which do you think is the better returning asset?
Hard to compare just on absolute terms right?
Now CAGR is a simple formula you can use to calculate how much your investments has grown year over year, compounding. The best part is even if at some point of the time your investments had gone down or up a lot, you can easily get the accurate return between two dates.
where, n = number of years of the investment.
Substituting the numbers for both the investments:
Comparing both investment’s CAGR, you can see that the House grew by 4.88% per year and stocks grew by 6.27% per year (compounded). Do note that these are just example numbers and not any real investments I did.
Points to remember
You have to remember that CAGR doesn’t show you how risky a particular investment is. It just shows your how much it has grown. Also since it is a smoothed out rate of return, you won’t be able to say how volatile the asset’s value was. You might have invested in a stock at Rs.100 and sold it at Rs.200, but the price of the stock might have gone from Rs.100 to Rs.50 to Rs.130 to Rs.250 to Rs.200. You won’t know this information in CAGR.
One major thing to keep in mind is most mutual funds proudly show the CAGR and investors go put in all their money in that without realising what kind of investment they are getting into. CAGR is just one of the various factors used to evaluate mutual funds. While investing in mutual funds, remember to read the Scheme Information Documents carefully and also research about the various ratios and assets the fund has invested into.