How is CAGR useful to investors?

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If you’re just beginning your investment career, one area in which you may encounter difficulty in comprehending the technical terminology especially associated with the financial markets. For example, you may have heard the term ‘power of compounding’ in reference to investment products such as mutual funds, bank fixed deposits (FDs), savings accounts, and equity stocks. While you attempt to understand the power of compounding, you must have also encountered something called compound annual growth rate (CAGR). You may have heard financial gurus use this term frequently when discussing investment alternatives, particularly those that stimulate interest.

What is this CAGR?

CAGR is a percentage-based measure used to determine the annual rate of return on investment over more than one year. In other words, CAGR informs you of the average rate of return on your investment over a specified period.

How is it calculated?

To calculate CAGR, you will need three values, i.e., Beginning value of the investment (BV), Ending value of the investment (EV), and the investment period (n)

CAGR= (Ending value of the investment (EV)/ Beginning value of the investment (BV)) ^1/ investment period (n)-1

Let’s understand it better with an example: Mr. Tarek Mehta, a writer by profession, invested Rs 1 lakh in April 2015 for a period of five years. At the end of the five years i.e April 2020 when he redeemed his investments, he received Rs 1.51 lakh. This indicates his investments grew by Rs 51,000. So, what is the CAGR he earned?

Let’s calculate the CAGR of Mr. Tarek Mehta by using the above formula.

CAGR= (Rs 1.51 lakh/ Rs 1 lakh) ^1/5-1 equals to 8.4%. In a similar way, you can check the CAGR for different funds with different time periods like 3,5,6, or 10 years.

So, in Mehta’s case, he earned a CAGR of 8.4% over five years. However, you should not assume that he made 8.4% returns every year for five years; that would be incorrect.

While CAGR is a commonly used and popular method for estimating mutual fund returns, one of its shortcomings is that it does not account for periodic investments. If, as in our previous example, many investments were made at random intervals throughout the year, CAGR will be unable to present an accurate picture. It is most effective when used on a point-to-point basis. Thus, CAGR is an appropriate statistic for one-time lump sum investments but not for SIP returns.

How is it useful to the investors?

-If you are a long-term mutual fund investor who has invested in a variety of schemes, you may use CAGR to determine the average return earned by each scheme over the course of your investment.

-If you have clear return expectations for your mutual fund investment, CAGR can be used to compare schemes and choose the ones that match them the best.

-If you have long-term financial goals, CAGR can be used to estimate the time required to reach them.

-You can compare a mutual fund scheme’s CAGR to its benchmark to determine whether the scheme is outperforming or lagging the benchmark.