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# Financial Term of the week- Compound Annual Growth Rate (CAGR)

When you invest in an instrument like mutual funds, your returns are not fixed every year. With changing market conditions, the returns can vary. Realizing the quantum of returns a mutual fund gives is an important factor because it helps you decide your future investment strategies. This can be measured by CAGR. CAGR helps you understand how much your investment has grown over a specific period of time. Or, it is the percentage of compounded annualised returns garnered by you through your investment for a specific period.

CAGR represents the average annualised rate of compounded return. For example, let us assume that you invested Rs 1,00,000 which after 6 years grew to Rs 2,20,000. What you often calculate is the absolute return, which is nothing but the % return irrespective of the time period the money was invested for. In this case, the absolute return is 120% [(220000-100000)/100000] %. However, the CAGR for this same investment will be 17.08%. And depending on the number of years you calculate CAGR for, it will keep varying while the absolute return will remain constant so long as the final and invested value is the same. Let us see how the CAGR in the above example is calculated.

## How is CAGR calculated?

Let us understand this with an example. Assuming you invested a lump sum amount of Rs 1,00,000 in a mutual fund, your hypothetical returns are listed below year-wise-

Table 1-

Investment Value (IV)= Rs 1,00,000

Final Value (FV)= Rs 2,20,000

Investment intervals (n)= 5

CAGR= 17.08%

As you can see, if you change the number of years, the CAGR can change dramatically. It gives you the picture of the average annual returns that a fund or a collection of funds have provided over a period of time. You can calculate this for one fund or all your investments combined as well.

## Things to keep in mind about CAGR

1. It does not factor in the periodic volatility

CAGR assumes an average growth. If you compare CAGR returns with the actual returns, you will see that the negative and positive returns every year are not captured. Instead, it averages out the returns over the investment period.

If you derive the YoY returns using the CAGR; it will look something like this-

Table 2-

Whereas, if you look at the actual returns in Table 1, there was an interval of negative growth as well between Year 3 and 4. These spikes and falls are not captured in the CAGR.

2. Periodic/irregular investments may not get accounted for accurately

Even though CAGR is very popular and widely used for calculating mutual fund returns, it does not take irregular investments into account. For example, in the above illustration, if the investments made were multiple times every year and spread out in nature, then CAGR may not give you a precise picture. Hence, CAGR may be more effective in case of lumpsum investments but less effective in case of SIPs.

## In conclusion-

Even if you invest a small amount of money each year in mutual funds, it is important to understand what kind of growth path is the invested money on. A measure like CAGR can help you understand the growth or de-growth curve of your investment. It can even be employed to measure the performance from any other mode of investment that you may be delving in, like gold. When reviewing your portfolio, it is advisable to ensure that CAGR is monitored closely.

Disclaimer:
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