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- Investing in stocks, commercial real estate, mutual funds, or any asset for that matter involves gaining a clear understanding of the tools that will help measure the growth of your investment:
- Is your investment on track? Are the returns at a rate you expect them to be? Are the long term returns going to be worth your investment, should you look to liquidate? I know, that’s a lot of tough questions.
- Exactly why understanding a metric such as Compound Annual Growth Rate, or CAGR is crucial. CAGR is a metric that plays a pivotal role in assessing your investment performance, and making projections about the rate of return.
- In this article, we’ll look at the significance of CAGR in investments, demystify its calculation, and see what it means for long term financial planning.
CAGR Explained
- At its core, CAGR is a powerful metric that gives you the annual rate of growth for an investment over a specified period. Most metrics provide the average annual returns.
- Where CAGR differs is in how it includes the compounding effect, which provides a more accurate representation of how your investment is performing.
- Imagine you’ve planted a seed that grows into a money tree. Every year the plant grows a little taller, and after a few years it’s turned into a huge money tree.
- It might appear that the plant grew more tall in some months as compared to other months, where growth wasn’t too fast or visible. This is where CAGR comes in. Using CAGR is like asking, on average, how much the plant grew every year.
- To put it simply, CAGR tells you the rate at which an investment would grow if it grows at the same rate every year, and if the profits are reinvested at the end of each year.
How CAGR Works
- Let’s take an example. If you invested Rs 10,000 in a mutual fund, and it grew at a rate of 15% over 5 years, it shows that your investment increased on an average, 15% each year. The actual yearly growth might vary; the fund could’ve grown by 10% the first year, and maybe 17% the next year.
- Using CAGR as a metric to calculate and determine returns gives you a smoothed rate of return: It’s not the true return rate, but a figure that represents the rate at which an investment would have grown, accounting for different factors.
CAGR Formula: How CAGR is Calculated
Here, the ending value is the total value of investment at the end of the investment period.
The beginning value is the value of investment at the beginning of the investment period.
The no. of years is the time period of investment in years.
CAGR vs Other Investment Metrics
CAGR vs XIRR
XIRR means the extended internal rate of return. XIRR is another metric heavily favoured by experts and industry analysts alike. It’s used to calculate the rate of return in case of investments where cash flows happen at irregular intervals.
The major difference between CAGR and XIRR is that XIRR takes into account all the cash inflows and outflows, as well as the specific dates and time on which they occur. Then XIRR uses all this information to calculate the annual rate of return, which makes it a more preferred and accurate method for funds (or investments), which have irregular cash flows.
Key Difference
XIRR is mostly used when evaluating the returns of funds with irregular cash flows, and CAGR is the go to choice when you are evaluating mutual funds (or any other investment) which has a regular cash flow:
CAGR provides a constant rate of growth, which is why it is ideal for investments which have consistent cash flows and investment, and CAGR is preferred for long-term analysis of investments.
CAGR vs Average Annual Returns
There is a large dichotomy between CAGR and the average annual returns of an investment. In average annual returns, each year is treated equally. CAGR, like the name says: uses the power of compounding. This is an important distinction for investors who are looking to understand the true growth of their investments.
CAGR & Investment Returns
There are a lot of uses for CAGR in financial planning and how it can help you make better investments.
Compare Performance: CAGR gives you a standard metric to analyse and compare your different investments over the same time period. You can compare the Compound Annual Growth Rate of two different investments and see how well one stock did against others in your portfolio.
Long Term Investment Strategy: By using CAGR to estimate the potential growth of an investment over, let’s say, a period of 3 or 5 years, you can make sound, long term financial decisions. You can estimate the future potential value of your investments and then act accordingly.
Assessing Investment Risk: If the calculated CAGR of an investment has been consistently positive over a long period of time, it is safe to say that it is a stable and secure investment; based on the optimistic growth patterns it provides.
This is ideal for conservative investors, or anyone looking to mitigate investment risks. On the other hand, investments showing low CAGR or even a negative CAGR (losses over time) are probably not the best bet to make.
CAGR Limitations
Like any other performance analysis metric, Compound Annual Growth Rate does have its limitations as well. Because CAGR provides a smoothed rate of return over a period of time, it works on the assumption that the growth during the entire time period was steady and stable.
Thus, it ignores market volatility, any irregular cash outflows and inflows, and works best when the fund or investment works with a stable and consistent cash flow.
Secondly, no matter how good or positive the CAGR is, it cannot, and should not be used to assume that the growth rate will remain the same in the future. Therefore, it is best to use CAGR over longer periods of time to provide more accurate analysis of different investments.
Bottom Line
To bring this to a close, CAGR is a useful financial metric. It is a tool that can empower investors to make informed decisions while they navigate the financial market.
Using CAGR in conjunction with other analytical metrics such as XIRR can provide a healthy projected picture of your investments: be it a mutual fund, stocks, commercial real estate, and so on.
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