Have you ever wondered how to calculate the returns from your investments?
If so, this article is great news for you. You’re going to learn a technique called CAGR.
This post will teach you everything you need to know about CAGR and how to use it in your financial calculations.
Here’s a quick rundown of what we’ll cover next:
What is CAGR?
CAGR stands for “Compound Annual Growth Rate” and it can be calculated for almost anything that can go up or down in value over time.
CAGR can be used to describe multiple fields of study. However, it is primarily used in finance, economics, and demography.
The compound annual growth rate (CAGR) of an investment is the mean annual growth rate of an investment over a specified period longer than one year.
In simple words, it shows you how much your investment has been earned each year for a given time interval.
A positive CAGR means that your investments increased, while a negative CAGR means your investments decreased.
How to calculate CAGR?
You can calculate CAGR by using the following three parameters:
- Beginning Value of Investment
- End Value of Investment
- Period of Investment (Years)
The mathematical formula for measuring CAGR is:
For example, if the beginning value is Rs 1,000, and the end value is Rs 2,500 with an investment period of 5 years, the CAGR is calculated as follows:
CAGR = (2,500/1,000)^(1/5)-1 = 20.11%
Don’t worry, you don’t have to calculate manually. I am here to make your life easy.
We have our very own online CAGR Calculator.
Just enter Values and you will get the CAGR in microseconds.
Pros and Cons of CAGR
CAGR is one of the most reliable metrics to estimate the growth of your investment because it calculates compound interest. Unlike the absolute rate of returns, CAGR provides a more precise estimation.
Let us have a look at the pros and cons of CAGR:
Pros of CAGR:
- CAGR helps you in providing a better understanding of the performance of the company in comparison to another. You can make accurate investment decisions which can result in higher profitability for you.
- CAGR provides a simple way to assess and compare past returns of a listed company in the stock market that helps you understand the strengths and weaknesses of companies.
- CAGR assists you in comparing your investment returns with those from other investments.
- CAGR is also used as a measure of volatility and risk, as it indicates the amount of uncertainty in an investment or portfolio.
- The most important advantage of CAGR is that it calculates the annualized rate at which an investment in a mutual fund scheme or an equity share has grown over a specific time horizon. Thus, by calculating CAGR, you can determine if your investments have achieved the target you had earlier set for them or not.
- CAGR helps you in smoothing out the volatility associated with short-term performance.
Cons of CAGR
CAGR is a useful metric for many purposes, but it has some limitations that you should be aware of.
1. CAGR doesn’t indicate market volatility:
The most important limitation is that CAGR doesn’t tell you much about actual investment performance.
A single annualized return number doesn’t offer any sense of what’s going on underneath.
It can hide a lot of volatility in an investment or make an extremely volatile investment look less so.
For example, if your Rs. 10,000 investment goes up to Rs. 15,000 in one year, then down to Rs. 5,000 the next year, and then back up to Rs. 15,000 the following year, the CAGR over those three years is 0%. But your actual portfolio value was all over the place.
If you didn’t know this, you’d think that your portfolio had been stable when it was anything but stable.
In fact, in this case, it would be misleading to use CAGR at all because it hides the fact that your portfolio went down by 50% at one point.
2. CAGR doesn’t count as deductions from investment:
CAGR assumes that all dividends or interest payments are reinvested back into the fund.
It means that if you are living off the income from your investments and not reinvesting your distributions, then it will give you an inaccurate picture of your investment performance.
CAGR is a good metric for comparing investments with different initial costs and final values.
However, it doesn’t account for how much money you initially invested in your investment or how much you later withdrew from it.
CAGR only gives an accurate measure of returns if the rate of return is constant each year. This means that if your portfolio performance is volatile and varies each year, the CAGR will not give you an accurate picture of your investment performance over time.
5. Not applicable in SIP:
CAGR may not be an appropriate measure for calculating returns for investments made under the Systematic Investment Plan (SIP).
Only the beginning value of an investment is considered for calculating CAGR.
How Does CAGR Differ from XIRR or Other Similar Metrics?
CAGR is the idealized rate of return between two dates.
It’s easy to use and understand, but it differs from some other metrics you might use that also try to represent the “effective” rate of return on an investment over a while.
Let us discuss other important metrics for calculating the rate of return on investment:
What is XIRR?
XIRR (Extended Internal Rate of Return) is a financial function that can calculate the rate of return for investment when the payments and cash flows are irregular.
As compared to CAGR, XIRR is a more accurate way to calculate your returns on investments made periodically over a period of time.
It takes into account the exact dates that investments were made and received during the entire investment period.
In other words, the XIRR calculates the compound interest earned on investments made at intervals rather than at a single point in time.
However, the formula for XIRR isn’t perfect.
It may come as a surprise that both unrealized and realized gains are included while calculating XIRR. The formula also assumes that the money withdrawn earns a similar return.
What is the Absolute Rate of Return (ARR)?
The absolute rate of return is the amount of money gained or lost on an investment over a period of time, expressed as a percentage.
The absolute rate of return is calculated by dividing the amount gained or lost over the period by the initial value of the investment.
For example, if an investor buys shares for Rs 10,000 and sells them for Rs 12,000 one year later, then he has made a profit of Rs 2,000. Dividing this by the original value gives an absolute rate of return of 20%.
The absolute rate of return gives a measure of performance that is independent of time, making it easier to compare different investments.
However, it does not consider inflation or other factors that may also influence the value of money over time. As such it provides only a limited measure of performance and should be considered in conjunction with other measures.
If you are looking to start a long-term investment plan, CAGR is the best method to use.
It can help you track the growth of your investments and avoid volatility.
Keep close tabs on your investment choices by tracking CAGR to guide your investments wisely to earn the maximum returns.