What is CAGR?
CAGR refers to the mean annual growth of an investment over a specific time duration. It is assumed that the value of investment is compounded over the duration. Unlike absolute return, CAGR takes time value of money into account. As a result, it is able to reflect the true returns of an investment generated over a year.
The CAGR can be calculated using the mathematical formula
CAGR = [ (Ending value/Beginning Value)^(1/N) ] -1
The above formula depends on three variables. Namely, the beginning value, ending value and Number of years (N)
When you input the above three variables, the CAGR calculator would give you the rate of return on investment.
For example, if you had a beginning value of investment of Rs. 1000 and the ending value of investment of Rs. 4000 over a period of two years. Then your CAGR would be 100%
CAGR = [(4000/1000)^(1/2)]-1
How To Use CAGR Calculator
Where can you use CAGR calculators CAGR is an easy to use tool to analyse your investment decisions. It finds application in the following scenarios:
1. You bought some specific units in equity funds this year and your fund value increased. With the help of CAGR calculator, you would be able to know the rate of return on your investment
2. You want to start investing and have some specific goals. With the CAGR calculator, you will get to know at what rate you have to grow your money within the time frame
3. Consider you have invested in an equity fund whose 3,5, and 10-year returns are 30%, 18% and 12% respectively. You want to know the average rate at which your fund grew annually
4. To compare the CAGR of an investment with your expected rate and check for the suitability. Invest only if the CAGR is greater than or equal to your expected rate of return
5. CAGR of a mutual fund can be compared with a benchmark return to know if it’s doing good or bad in the market
Limitations of CAGR
Even though CAGR is a useful concept, it has a lot of limitations. A lack of awareness of these limitations would lead to bad investment decisions. Some of the limitations are:
In calculations related to CAGR, it’s only the beginning and end values. It assumes that the growth is constant over the duration of time and fails to consider the volatility aspect
It is suitable only for a lump sum investment. As in case of a SIP investment, the systematic investment at various intervals wouldn’t be considered as only the beginning value is considered while calculating the CAGR
CAGR does not account for the risk inherent in an investment. When it comes to equity investment, risk-adjusted returns are more important than CAGR. For these purposes, you need to consider better ratios like Sharpe ratio