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Annualized return and CAGR are not technically the same thing. They refer to the returns on various investment options computed on per annum basis. All long term investments multiply by your wealth by compounding.
Where investment has grown at different rates over a few years, CAGR is the formula used to define the number at which the investment has grown year on year.
Compounded Annual Growth Rate (CAGR) shows how much a person’s investment grew in one year. In other words, it is the average returns an investor earns on his investments after one year. The bank or the financial institution calculates this rate in terms of annual percentage.
How to calculate CAGR?
To calculate CAGR, you must know the following:
- The investment made in the initial year (the year of investment)
- Amount invested in the current year and
- Tenure of investments
CAGR = [(End value/beginning value)^(1/year)] – 1
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%.
Mutual Funds/Equity and CAGR
Return on any investment is discussed in terms of CAGR. Especially, in case of equity and mutual fund investments. When you invest in mutual funds, the return that is shown in CAS statements and your Dmat statements are in CAGR.
This is because the actual return % on mutual funds is dependent on the movement in the stock market which keeps changing. It never grows or falls at a fixed rate.
Hence, it could be possible that an investment in mutual fund grew at the rate of 20% in year 1, 30% in year 2, 10% in year 3. In such a case, it becomes very difficult to discuss the actual gains. This is when and why CAGR is used in market-related variable returns investments.
In our Article, how to set goals, we have discussed the expected returns on various asset classes, we are always talking about CAGR.
Wealth Cafe Note:
- CAGR is an average rate. Hence, if a CAGR is of 15% of an investment made for 4 years. It could be possible that the first 3 years have 30% gains and the next 2 years lower gains.
- The gains are not distributed evenly over the period of investments. One must stay invested for the right time based on the asset class to benefit the most.
- CAGR is different from absolute returns and year-on-year gains.
- There is a chance that 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.