Compound Annual Growth Rate (CAGR)

One of the main reasons people prefer to invest is the power of compounding factor, which is considered as the eighth wonder of the world in terms of financial terminology. Power of compounding helps to grow your funds significantly. While it is easy to calculate the compounding effect for the fixed returns investment instruments, it may not be easy to calculate the compounding effect for mutual funds whose value fluctuates constantly. It is where Compound Annual Growth Rate (CAGR) comes into the picture. If you are about to invest in mutual funds, you should be aware of CAGR and how it works

What is CAGR?

Since the returns generated nu Mutual Funds are market linked, CAGR is one of the most effective ways to calculate it. You can compare the CAGR of different schemes to get excellent insights as to how a fund performed over the years. Based on the CAGR, you can pick the best scheme that meets your investment objective. CAGR does not take into account the risk associated with investing. Moreover, the time horizon you invest plays a vital role in your returns. 

For example, If you have invested Rs. 1 Lakh in mutual funds, you’ve given the investment a time horizon of 5 years, then the investment grows to Rs.150000, it means your investment has grown by Rs. 50000. CAGR per year can be calculated as follows

CAGR = (Return/Investment) ^ (1/T) – 1

Using the above formula if we calculate then we get the following results,

CAGR = (1,50,000-1,00,000) ^ (1/5) – 1 = 8.71%

How can you use CAGR?

CAGR is one of the most effective ways to calculate the average returns that a mutual fund generates over a time period. You can change the tenure and check how the fund has performed over the years. Also, you can pick schemes by comparing the CAGR of different funds. Duration plays a very important in determining the right CAGR

Lets illustrate this with an example.

For example, if A invests a particular amount and generates a CAGR of 40% in the last 1 year, B has generated 60% CAGR in the same span, it seems to us B is the normal choice when compared with an investment horizon of 1 year. However, let’s consider a long term investment horizon

However, at the end of 5 years, you can clearly see, fund A gives you better returns compared to B. As you invest on a long-time horizon, you get stable returns. 

Usage of CAGR

• Plan your long-term financial goals by using CAGR values, it can be used to predict when you will be able to achieve your goals
• You can use the CAGR data  to check if the fund performs to its benchmark
• If you have some specific return objectives, you c an use CAGR of different schemes and select the best one

Apart from Mutual Funds, CAGR can also be used to analyze stocks and other  market-related instruments.