What is common between mutual funds, bank FDs, savings account, PPF, and stocks? They can all help you grow your wealth with the power of compounding. CAGR can be used for calculating how these investment options grow your wealth over a period. Read this post to understand CAGR.
If you are starting your investment journey, one thing that you might struggle with is understanding the technical terms and terminologies used in the financial markets. For instance, you might have heard the term 'power of compounding' mostly in regard to investment options like mutual funds, bank FDs, savings accounts, equity stocks, etc.
Try to understand this power of compounding, and you will be introduced to something known as CAGR. You might have also heard financial experts commonly using this term while discussing investment options, especially ones that generate returns in the form of interest.
So, what is this CAGR? Before talking about CAGR, let us first try to know the meaning of compounding.
In simple words, compounding is when you earn returns on the returns already generated by an investment. The simplest example to help you understand compounding is through a bank FD. When you open an FD account, you get into an arrangement which says that the bank will pay you interest at a certain rate if you remain invested for a specific duration.
Now, rather than withdrawing the interest income generated by your FD, if you decide to re-invest it in the same FD, you will earn interest on the principal amount as well as the interest income that you have re-invested. This cycle can continue repeatedly as long as you remain invested.
This is how compounding works. If you let compounding work its magic for multiple years, you can generate handsome returns. Apart from investment options that generate interest income, compounding also works in other options such as mutual funds and even stocks.
CAGR or Compound Annual Growth Rate is a percentage-based metric used for determining the annual rate at which an investment grows over a certain period of more than one year. In other words, CAGR helps you know the average returns your investment is earning over a period.
For instance, if you invest in an equity fund and go with the growth option where the profits are re-invested in the same fund. So, the returns from your investment will vary every year. The CAGR will help you know the exact percentage of returns your investment is earning every year throughout your investment tenure.
A lot of new investors, especially mutual fund investors, confuse CAGR with AAR (Average Annual Returns). But they are entirely different concepts.
AAR helps you know the average returns your investment has earned over a period. For instance, an AAR of 10% of a mutual fund scheme over a period of 5-years might look very impressive. But the scheme might have generated-
40% returns in the 1st year
20% returns in the 2nd year
10% returns in the 3rd year
-5% returns in the 4th year
-15% returns in the 5th year
So, the total returns in percentage are 50% over five years. This means that the AAR here is 10% (returns/number of years), which is very decent.
But the returns are consistently falling in the last two years. The AAR fails to help investors know the exact returns an investment has generated every year. Moreover, it also ignores compounding.
This makes CAGR a better metric as its calculation also takes losses and the effect of compounding into consideration. As a result, investors get a clearer picture of the exact rate at which an investment has grown in line with a consistent rate of compounding.
Now that you know what is CAGR, it would help to understand how it is calculated.
You'll need three values for calculating CAGR-
Beginning value of the investment (BV)
Ending value of the investment (EV)
Investment tenure (n)
CAGR formula is as follows-
CAGR = - 1
For example, let us consider that you invested Rs. 1,00,000 in shares of a particular company. At the end of the first year, the initial investment amount appreciated to Rs. 1,25,000. It appreciated again and reached Rs. 1,50,000 in the second year. So, the AAR here is 50% for two years of your investment.
But if you'd like to know that rate at which the investment grew throughout the tenure of 2 years, you can use CAGR. Replace the values in the CAGR formula, and you will see that the CAGR of the stock in the last two years is 22.47%.
These are some of the most important things you should know about CAGR-
CAGR is generally considered a more accurate method for charting the growth of an investment as it considers losses and effect of compounding
When comparing CAGR of two investments, make sure that the calculation considers the same investment duration for both the options
CAGR never considers the risk level of investment so don't invest solely based on CAGR
CAGR is generally calculated on time frames ranging from 3 years to 7 years
Now that you know CAGR meaning, you can use this metric to make better investment decisions. While metrics such as annual returns and AAR are commonly used for analysing mutual funds and stocks, the compounding factor is overlooked in these methods. Due to this, these metrics often overestimate the returns and can lead to wrong decisions.
By considering a standard rate of compounding, CAGR can provide more accurate results. Moreover, it can be used to analyse the performance of an investment, compare stocks or mutual funds, and even for tracking business performance.