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“Compound interest. Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.” – Einstein

This timeless statement could be the driving force behind all wealth-building cum tax-saving investment schemes. Exploiting the power of compounding is no rocket science – all you need is some basic info and financial discipline. Let’s see how Compound Annual Growth Rate can drive your financial goals to fulfillment and mega wealth.

  1. What is Compound Annual Growth Rate?
  2. How to calculate CAGR?
  3. CAGR & Mutual Fund Returns
  4. What should investors know about CAGR?
  5. What are the other ways to determine returns?

 

1. Compound Annual Growth Rate

Any investment that offers you the benefit of compounding can help you double your investment and build wealth. CAGR shows how much a person’s investment grew in one year. In other words, it is the average returns an investor has earned on the investments after one year. The bank or the financial institution calculates this rate in terms of annual percentage.

A single stock or a mutual fund cannot provide you a constant rate of return every year. The rate may change from year to year. Furthermore, if you make repeated investments, you need to know the return earned on all the investments together. For instance, say you have invested in ELSS with a five-year tenure. CAGR tells you how much return a fund earned you every year during this period. However, this is applicable only if you re-invest your gains every year.

 

2. How to calculate CAGR 

To calculate CAGR, you must know these three numbers.

a. The investment made in the initial year (the first year of investment)

b. Amount invested in the current year and

c. Tenure of investment.

Let’s have a look at the following example to make the process clearer:

The formula for CAGR is:

CAGR

For example, you bought a stock for ₹100 in 2015. It appreciated by 25% to ₹125 in the year 2016 and further appreciated to ₹150 in the year 2017. Therefore, the appreciation in the rate from 2015 to 2017 was 20%.

If you want to know the growth rate of your investments for the complete period of time, use CAGR. If we put the above values in the formula, Compound Annual Growth Rate for your investment between 2015 and 2017 will be 14.47%.

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3. CAGR & Mutual Fund Returns

When we deposit money in mutual funds, or even Fixed Deposits and PPF, we only know that it will fetch us 7% or 8% return every year. We never see how much returns we’d get in a period of 4 or 5 years. This is where CAGR helps with the concept of compounding interest coming into the picture. CAGR is generally used when the money you saved compounds for many years.

When you invest in a mutual fund, the growth rates that you see are not expressed in absolute returns, but CAGR. Absolute returns are calculated by subtracting the amount you invest in the initial year from the amount accumulated in the ending year, which is then divided by the beginning year value. On the other hand, CAGR tells the percentage of returns for a selected time frame, without highlighting the returns on investments for every single year. Mutual fund investors should consider CAGR while assessing their returns to understand how much they have earned altogether.

 

4. What Investors should know about CAGR

a. The CAGR is not an indicator of sales that happened from the starting year to the last year. In some cases, all the growth may be concentrated only in the initial year or in the end year.

b. Sometimes, two investments may reflect the same CAGR, with one being more lucrative than the other. This could be because the growth was faster in the initial year for one, while the growth happened in the last year for the other.

c. They usually use CAGR for investment periods ranging from 3 to 7 years. If the tenure is more than, say, 10 years, then the CAGR may camouflage the sub-trends in between.

d. Remember, Compound Annual Growth Rate is different from year-on-year (eg: return on 21 March 2017 vs that on 21 March 2018) growth rate

 

5. Other ways to determine returns

There are other types of returns, besides CAGR, that are useful in analyzing the performance of mutual funds.

a. Annualized returns

It is the geometric average amount of funds that an investment creates every year for a fixed period of time. Annualized returns signify the return rate an investor earns for a given period, considering the annual compounding of returns. This gives clarity on how the investment would perform without focusing on the market volatility of markets.  

b. Trailing returns

This is useful for calculating the historical performance of your funds on daily, weekly, monthly or annual basis. Trailing returns method is perfect for one-time investment. If you invest an amount on 17th April 2017, the 1-month trailing return period will range from 17th April 2017 to 17th May 2017. 

c. Return since launch

One can ascertain the value of Return Since Launch from the time an NFO (New Fund Offer) gets closed. They calculate it at an opening Net Asset Value of ₹10.

In a nutshell, in spite of other methods, CAGR is far more reliable to track the growth of an investment. This is mainly because the annual return rate doesn’t take the compounding factor into consideration, leading to overestimation. Thus it is useful to understand how a mutual fund grows in terms of CAGR and use it to compare different funds. If such in-depth research is not for you, then you can invest in our hand-picked mutual funds from the country’s top fund houses.

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