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What is CAGR and how it is calculated
CAGR refers to the Compound Annual Growth Rate. It is a measure of the annual rate of growth of an investment over time, taking into account the effect of compounding. It is often used for calculating and evaluating past investment results and predicting their expected future returns.
What is CAGR (Compound Annual Growth Rate)
CAGR is an acronym for the Compound Annual Growth Rate, as we described in the introduction. CAGR's formal concept states that CAGR is the annual return rate that an investment needs to grow from its initial balance to its final balance within the given period. CAGR is based on the premise that at the end of each year of its time horizon, earnings are reinvested.
You should be mindful that the compound annual growth rate is an estimate rather than a real rate of return. You may assume that CAGR is a number that represents the rate at which investment would have increased if it had risen at the same level each year over the entire investment period (with the assumption that at the end of each year the gains are reinvested).
Clearly, such a scenario is nearly impossible in real life. Nonetheless, CAGR is mainly used to smooth the return rate over the entire investment cycle and is therefore very useful when comparing various investments.
Advantages of CAGR
- CAGR is one of the most reliable ways of estimating the return on an investment which increases and decreases in value over the investment period.
- CAGR helps investors to compare different time horizons to investments.
- CAGR allows risk-free instruments to measure returns from a particular investment. It also allows you to determine whether the risk-taking premium is sufficiently high.
Limitations of CAGR
- The investment risk is not taken into account by CAGR.
- It does not reflect the uncertainty of the investment value as CAGR represents a steady growth over the investment period. In addition, CAGR implies a constant rate of growth.
- During the investment cycle, the profitability of an asset with inflows and outflows cannot be measured with CAGR. It's because the CAGR just measures the return rate on the basis of the portfolio's initial and final balance.
CAGR for Mutual Funds
In the case of an investment path such as mutual funds, you need to figure out whether or not it is worth investing. You need ways to calculate your success over a given period of time. The fact sheet of the mutual fund would provide the fund with growth rates over different time horizons. Judging the fund's output based on multiple factors may seem confusing. On the contrary, if you could know how it grew every year, then things could become simpler.
By providing you with a single annual growth rate, CAGR will help here. Besides this, the principle of compound interest is also placed in the scene. To calculate returns, most investment strategies, including mutual funds, use compound interest. CAGR would, therefore, be an acceptable way to measure the quality of the investment.
How to calculate CAGR
The common CAGR formula is
CAGR = [EV/BV] (1/n) - 1
- EV stands for End Value of the Investment
- BV stands for Beginning Value of the Investment
- n stands for Number of investment period in months/years
The CAGR calculator will give you the rate of return on investment when you enter the above three variables.
Applications of CAGR formula
The CAGR formula can be used in the following scenarios to analyze your investment decisions:
- This year you bought some specific units in equity funds and increased the value of your fund. You'd be able to know the rate of return on your investment with the aid of the CAGR formula.
- You want to start investing and you want to have some specific objectives. With the CAGR formula, you'll find out at what rate you need to grow your money over time.
- Consider investing in an equity fund with 3, 5, and 10-year returns of 30%, 18%, and 12% respectively. You want to know the average annual growth rate of your account.
- Comparing an investment's CAGR with your expected rate and checking for suitability. Invest only if the CAGR meets or is equal to your expected return value.
- You may equate the CAGR of a mutual fund with a benchmark return to know if it does well or bad on the market.
In a nutshell, CAGR is much more accurate to chart an investment's growth given other methods. This is mostly because the compounding element is not considered by the annual return rate, which contributes to overestimation. It is, therefore, useful to understand how a mutual fund is growing in terms of CAGR and to use it to compare various funds.