CAGR - What is Compound Annual Growth Rate and How to Calculate CAGR?

When you invest in mutual funds, especially equity mutual funds, your returns are not the same each year. There is an inbuilt degree of variance or volatility built into the rate of return your investments grow by annually. Typically, this takes place due to a change in market conditions or due to a correction of previous market enthusiasm. Knowing how much an investment earned annually is also called CAGR or compounded annual growth rate.

As a measure, CAGR is helpful to track the performance of your investments. Further, it informs how you deploy capital across your investments. This makes CAGR a potential key metric to consider while forming and executing your own investment strategy across a well-diversified portfolio.

With changing market conditions, the returns can vary. Realizing the quantum of returns a mutual fund gives is an important factor because it may help you decide your future investment strategies. This can be measured by CAGR.

What is CAGR?

The CAGR full form is compounded annual growth rate. Simply put, it is the average number of an investment’s return over a period of time - like 3 years, 5 years, 7 years, or 10 years. This return is considered compounded as all the growth or returns in an investment takes place on top of any previous growth or returns.

The things to keep in mind about CAGR are:

• The time period in which CAGR calculation can be most effective is annual returns or average returns/year.
• It does not factor in market volatility or other factors that can make an investment suitable.
• Unless you sell or redeem your investment, all its growth and returns take place on previous growth and returns. Hence, CAGR factors in compounding.

The rate of this return and growth is counted from an annual perspective, which breaks down how your investment has performed over the period of a year, a standard unit of measuring returns.

Thus, the CAGR number represents an annual rate of compounded return on your investment.

How to Calculate CAGR?

The key thing to understand about CAGR is that it is a calculation of average investment return over a period of time. So, for example, if your average returns on an investment are 15%, it acts as a base for CAGR.

The steps to calculate CAGR or compounded annual growth rate are:

Divide the investment’s current value (at the close of time frame you are measuring for) by the value at the beginning of that period.

This result should be raised to a mathematical exponent of one divided by the number of years the investment has been held.

Subtract one from the result at the end of step 2.

Multiply the resulting decimal by 100 to reveal a percentage CAGR calculation.

Now, consider this table of year-wise returns on a Rs 1,00,000 lumpsum investment:

However, once we have this data and apply the CAGR to each year’s returns, a different picture emerges.

CAGR Formula

The formula for CAGR calculation is illustrated below.

CAGR = (FV / IV) ^ (1 / n) - 1

The elements of the CAGR calculation formula are:

FV can be interpreted as a term used for the current value of an investment.

IV is the value of the investment, or how much money has been put into the asset.

N stands for the number of years you have invested for, whether it is a whole number or its decimal units. For example, 4 years and 3 months can be represented by an n of 4.25.

As you can see, if you change the number of years, the CAGR can change dramatically.

Since the number of years is a key variable, the CAGR alters meaningfully as the number of years change. A back of envelope calculation can show you that 72% absolute returns over 4 years show a CAGR of 18%, while the same returns over 9 years result in a CAGR of 8%.

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.

Why is CAGR useful to you?

CAGR is a simple numerical answer to the question: what is the average return of this investment over the period of time I have held it?

It achieves this by overlooking volatility and focusing simply on the duration an investment is held for, the invested amount, and the closing or ending value of an investment for the duration of which the CAGR, or compound annual growth rate, is being calculated for.

While compound annual growth rate does not tell you how the fund has performed in each specific year or its ups and downs along the way, it gives you a clear picture of a fund’s average performance for a duration, whether 3 years, 5 years, or any other duration in years.

Additional Read: What is Statutory Liquidity Ratio?

Use of CAGR

CAGR is considered a ‘representational’ figure or a proxy. It does not factor in the actual, ongoing performance of a fund. It does not factor in market volatility or the variance in returns through evolving market conditions. If we are to draw a parallel with daily life, it is like calculating a car’s fuel average by answering “how much mileage do you get?” rather than talking about how dense was the city traffic you drive in or your individual driving style.

This is called a ‘smoothing effect’ - in which a clear answer that can be used as valid regardless of the operational or day-to-day price volatility that assets may undergo from changing market conditions.

CAGR, like a car’s mileage or a company’s sales for a quarter, is a measure of something after it has occurred.

CAGR in mutual fund

CAGR is a valid and important measure to track your mutual fund returns. It gives you a direct numerical answer that takes you to the heart of a mutual fund or portfolio’s returns over a period of years - whether this is over the time of two or twelve years.

The CAGR calculation takes place on applying the CAGR formula. However, this can be applied to a single mutual fund or even a portfolio of mutual funds.

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-

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 a simple and widely used method to calculate the average returns on an investment, it is not a tool suited for irregular and ongoing investing. For example, in the above illustration, if the investments made were multiple times every year and spread out in nature, then the CAGR may not give you a valid or complete picture. Hence, CAGR can paint a more complete picture of average returns for lumpsum investments than for SIPs or inconsistent investments.

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 the invested money is on. A measure like CAGR can help you understand the growth or degrowth curve of your investment. When reviewing your portfolio, it is advisable to ensure that CAGR is monitored closely.

Additional Read: What is PEG Ratio?