“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. Compounding the accumulation of your savings is the best way to build wealth.
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.
CAGR shows the mean rate of return that an investor has earned on his or her investments during a specific period exceeding one year. They calculate the rate in terms of annual percentage.
A single stock or mutual fund does not provide you a constant rate of return every year. The rate of may change from year to year. Furthermore, if you make repeated investments, you need to know the return earned on all the investments together. CAGR makes it easier for investors to ascertain that single rate of return that covers every amount of investment throughout the period.
Financial freedom is closely interlinked with discipline – go by ‘pay yourself first’ method and keep it aside to invest in schemes that utilize the full potential of compounding. It doesn’t matter how little or less you pay. ELSS is one example for an investment tool that can literally double your money in a certain tenure.
6 CAGR pointers to remember:
- Returns earned increase with more CAGR.
- The more you invest, the more you earn.
- Start early and think long-term. Say, if you invest 1000 per month at 10% CAGR, the overall sum invested in 20 years will be only ₹2.4 lakhs. But the returns will be over ₹25 lakhs.
- Risks increases with increase in CAGR.
- Choose and diversify investment plan wisely to earn inflation-beating returns.
- Always ensure you keep a balance between capital protection and high returns. Never give up one for the other.
So, rein the magic of compounding to advance yourself financially.
How is CAGR calculated?
To calculate CAGR, you would have to consider the amount of investment made in the initial year (the first year of investment), the amount of investment in the current or present year and the tenure of investment. Let’s have a look at the following example to make the process clearer:
The formula for CAGR is:
Say, 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%.
CAGR & Mutual Fund Returns
When you make investments in a portfolio for more than a year, the concept of compounding interest comes 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, calculated in percentage, are calculated by subtracting the amounts of the beginning year and ending year and dividing it by the beginning year value.
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 so as to see the complete returns earned.
When we deposit money in mutual funds, or even FDs 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.
Other types of returns
The other types of returns, besides CAGR, that are used to analyse the performance of mutual funds are:
Annualized return is the geometric mean amount of funds that an investment creates every year for a fixed period of time. It signifies the rate of return that an investor would earn for a given period, considering the annual compounding of returns. Without focusing on the volatility of markets, such returns give a picture of how the investment would perform.
This is used to calculate the historical performance of your funds on daily, weekly, monthly or annual basis. Quite user-friendly, trailing returns 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.
Return since launch
One can ascertain the value of Return Since Launch from the time an NFO (New Fund Offer) gets closed. It is calculated at an opening Net Asset Value of ₹10.