“Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.” – Einstein
This timeless statement is one of the driving forces behind wealth-building and tax-saving investment schemes. Exploiting the power of compounding is no rocket science – all you need is some necessary information and financial discipline.
Let’s see how the Compound Annual Growth Rate (CAGR) can drive your financial goals to fulfilment and mega wealth.
1. What is Compound Annual Growth Rate (CAGR)?
Compounded annual growth rate (CAGR) is one of the most commonly used terms in the mutual fund industry. CAGR represents the compounded growth rate of your investments made in mutual funds. It helps you gauge a mutual fund scheme’s average annual growth over a given time period.
2. How to Use CAGR to Analyse a Fund?
A single stock or a mutual fund do not provide you with a constant rate of return every year. The rate varies from year to year. If you reinvest, then you need to know the profit earned on all the investments together. For instance, say you have invested in ELSS with a five-year tenure. CAGR tells you the extent of return a fund provided you every year during this period. However, this is applicable only if you reinvest your gains every year.
3. How to calculate Compound Annual Growth Rate?
Most investors rely on absolute returns to analyse the performance of their investments. However, it does not consider the time value of money. On the other hand, CAGR takes into account the period for which you stayed invested in the given avenue. It gives you an approximate rate at which your investment would grow if there is no volatility.
It is an excellent way to factor the fluctuations experienced by the asset over a specific period. Then, you may easily interpret its performance over the particular horizon. It is one of the excellent means to gauge how a given investment fared as compared to its price.
You can calculate CAGR in three easy steps. You must know these three numbers:
a. The investment made in the initial year (the first year of investment)
b. Value of investment at the end of the year
c. Tenure of investment
You can calculate CAGR using our CAGR Calculator as well. Let’s have a look at the following example to understand the same better:
The formula for CAGR is:
For example, imagine you bought a stock at Rs.100 in 2015. It appreciated by 25% to Rs.125 in the year 2016 and further appreciated to Rs.150 in the year 2017. Therefore, the appreciation in the rate from 2015 to 2017 was 50%.
If you want to know the growth rate of your investments for the entire period, use CAGR. If we put the above values in the formula, Compound Annual Growth Rate for your investment between 2015 and 2017 will be 22.47%.
4. Compound Annual Growth Rate & Mutual Fund Returns
In case of an investment avenue like mutual funds, you need to ascertain whether it’s worth investing or not. For that, you require means to measure its performance over a given period. Mutual fund fact sheet would give growth rates across different time horizons of the fund. It may not be easy to judge the fund performance based on multiple rates. Instead, if you could know how it has grown annually, then things may get simpler.
This is where CAGR will help by providing you with a single annual growth rate. Apart from this, it also brings compound interest to the picture. Most investment avenues, including mutual funds, use compound interest to compute returns. So, CAGR would be the right way to measure fund performance.
5. What Investors Should Know About CAGR?
a. The CAGR is not an indicator of sales that happened from the starting year to the last year. In some cases, entire growth may be concentrated in the initial year or at the end of the year.
b. Sometimes, two investments may reflect the same CAGR, with one being more lucrative than the other. This could be because the growth was faster in the initial year for one, while the growth happened in the last year for the other.
c. They usually employ CAGR for investment periods ranging from three to seven years. If the tenure is more than, say, ten years, then the CAGR may hide the sub-trends in between.
d. Remember, Compound Annual Growth Rate is different from year-on-year (e.g., return on 21 March 2019 vs that on 21 March 2020) growth rate
6. What are the Other Ways to Determine Returns?
There are other types of returns, besides CAGR, that are useful in analysing the performance of mutual funds.
a. Annualised returns
It is the geometric average amount of funds that investment creates every year for a fixed period. Annualised returns signify the return rate an investor earns for a given period, considering the annual compounding of returns. This provides clarity on how the investment would perform without focusing on the market volatility of markets.
b. Trailing returns
This is useful for calculating the historical performance of your funds on a daily, weekly, monthly or annual basis. Trailing returns method is perfect for a one-time investment. If you invest an amount on 17 April 2019, the 1-month trailing return period will range from 17 April 2019 to 17 May 2019.
c. Return since launch
One can ascertain the value of return since launch from the time an NFO (New Fund Offer) gets closed. They calculate it at a first Net Asset Value of Rs 10.
In a nutshell, in spite of other methods, CAGR is far more reliable to track the growth of an investment. This is mainly because the annual return rate doesn’t consider the compounding factor, leading to overestimation. Thus it is useful to understand how a mutual fund grows in terms of CAGR and use it to compare different funds. If such in-depth research is not for you, then you can invest in our hand-picked mutual funds from the country’s top fund houses.