Compound Annual Growth Rate (CAGR) shows how much you earned on your investments annually in a given time period. It is one of the most commonly used terms in the mutual funds industry.
Calculate Compound Annual Growth Rate (CAGR)
- CAGR = {[(Ending value/Beginning value)1/n] – 1} x 100
- where n = number of years one has invested
Let us understand the calculation with an example. Vijay invested INR25,000 in August 2017. At end of August 2022, the amount invested had grown to INR70,000. Here the CAGR will be: {[(70000/25000)1/5 ]-1} x100 =22.87%
Compound Annual Growth Rate is a representational figure. Lets understand why by looking at the below example.
Suppose Amrita invested INR10,000 with the returns as follows: Year 1 ->the investment grew to INR12,000 (20% return). Year 2 -> the investment grew to INR16,000 (33.33% return) Year 3 -> the investment grew to INR24,000 (50% return). On an annual basis the returns are very different year on year.
The CAGR would be {[(24,000/10,000)1/3 ]-1} x 100=33.89%
So if Amrita had invested another INR1,000 in the same scheme, these would have also grown at a rate of 33.89% over a 3 year period. So CAGR shows the rate at which an investment and any reinvested profits on the investment would have grown annually. CAGR smoothens out or evens out all the spikes and lows during the investment period to display a consistent annual growth rate.
How to use CAGR?
- CAGR is used to measure the returns of an investment.
- It helps to make a meaningful comparison with another similar investment e.g. comparing returns from two mutual fund plans.
- One can also use CAGR to evaluate term life insurance plans where one has to invest a lumpsum amount and will receive a certain amount after 20 years/25 years.
Limitations of CAGR
- Does not reflect market volatility as it smoothens out all the spikes, lows during an investment period.
- Cannot be used to assess risk involved in an investment.
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