CAGR, or Compound Annual Growth Rate, is a financial metric used to calculate the average annual growth of an investment over a specific period, assuming the growth is compounded annually. It provides a consistent and comparable way to determine the performance of investments, regardless of their initial values or time frames.
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CAGR stands for Compound Annual Growth Rate. It's a metric used to measure the average annual growth of an investment over a specific period, assuming that the growth is compounded annually. In simpler terms, the CAGR tells you how much an investment would have grown on average each year over a period, taking into account the impact of compounding (where earnings from previous years are reinvested).
How Does CAGR Work?
CAGR works by calculating the average annual growth rate of an investment over a specific period, assuming that the growth is compounded annually. This means that the earnings from each year are reinvested, which can lead to significant growth over time. To calculate CAGR, you divide the ending value of the investment by the beginning value, raise the result to the power of 1 divided by the number of years, and then subtract 1. The resulting percentage represents the average annual growth rate of the investment.
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CAGR Formula and Calculations
To calculate the Compound Annual Growth Rate (CAGR), you can use the following CAGR formula:
CAGR = (Ending Value / Beginning Value)^(1/Number of Years) - 1
Where:
Ending Value: The final value of the investment.
Beginning Value: The initial value of the investment.
Number of Years: The length of the investment period.
Example:
Let's say you invested ₹10,000 in a mutual fund in India five years ago, and the current value of the investment is ₹20,000. To calculate the CAGR, you would use the following formula:
CAGR = (20,000 / 10,000)^(1/5) - 1
CAGR = 2^(1/5) - 1
CAGR ≈ 1.1487 - 1
CAGR ≈ 0.1487
To express this as a percentage, multiply by 100: CAGR ≈ 14.87%
Therefore, the compound annual growth rate of the investment is approximately 14.87%.
How is CAGR Used in Stocks and Mutual Funds?
Compound Annual Growth Rate (CAGR) is used in the following ways in stocks and mutual funds:
Evaluating performance: Investors use CAGR to gauge whether a stock or mutual fund has met their expectations and outperformed benchmarks.
Making investment decisions: CAGR can help investors identify stocks or mutual funds with consistent growth potential.
Comparing investments: It provides a standardized way to compare the performance of different investment options, such as stocks, mutual funds, and ETFs.
How is CAGR Used in ULIPs?
Fund Performance: CAGR is used to measure the growth of the underlying investment funds in a ULIP. This helps policyholders understand how their investments have performed over time.
Comparison: CAGR allows policyholders to compare the performance of different funds within a ULIP or across different ULIP products. This can help them make informed decisions about their investment choices.
Long-Term Returns: CAGR provides a clearer picture of long-term returns as it considers the impact of compounding. This is especially important for ULIPs, which are often held for a long period.
Risk Assessment: CAGR can be used to assess the risk-adjusted returns of a ULIP. This helps policyholders understand the relationship between the potential returns and the associated risks.
Example:
If a ULIP's underlying fund has a CAGR of 10% over a five-year period, it means that the fund has grown at an average annual rate of 10% during that time. This indicates a strong performance compared to other investment options
What are the Uses of CAGR?
Below are the uses of Compound Annual Growth Rate (CAGR):
Measure average annual growth: CAGR calculates the consistent growth rate over a period.
Compare investments: It allows for comparison of different investments.
Evaluate performance: Helps assess if an investment has met expectations.
Make investment decisions: CAGR can guide investment choices based on growth potential.
Smooth out volatility: CAGR provides a clearer picture of long-term growth.
What are the Benefits of CAGR?
Below are the benefits of Compound Annual Growth Rate (CAGR):
Consistency: CAGR provides a consistent measure of growth, smoothing out fluctuations that can occur in investment returns.
Comparability: It allows for easy comparison of different investments, regardless of their initial values or time periods.
Understanding compounding: CAGR helps investors understand the power of compounding, as it accounts for the reinvestment of earnings.
Decision-making: CAGR can be used to make informed investment decisions, such as choosing between different funds or asset classes.
Performance evaluation: It provides a clear metric for evaluating the performance of investments over time.
Risk assessment: CAGR can be used to assess the risk-adjusted returns of an investment, helping investors understand the relationship between potential returns and risk.
Disadvantages and Limitations of CAGR
Below are the disadvantages and limitations of Compound Annual Growth Rate (CAGR):
Historical measure: CAGR is based on past performance and does not guarantee future results.
Doesn't account for volatility: While CAGR smooths out volatility, it doesn't capture the risk associated with investments.
Doesn't consider specific time periods: CAGR provides an average growth rate over the entire period, not accounting for specific periods of high or low returns.
Doesn't consider external factors: CAGR doesn't factor in external events or economic conditions that can impact investment returns.
Can be misleading for short-term investments: CAGR may not be as effective for short-term investments due to the impact of market fluctuations.
Doesn't account for fees and expenses: CAGR doesn't consider fees, expenses, or taxes that can reduce investment returns.
Conclusion
The CAGR is an essential tool for evaluating the long-term performance of investments, providing a consistent and realistic view of growth. CAGR enables better comparison between different financial options and helps investors make informed decisions. Whether used for individual investments or broader financial analysis, CAGR simplifies the process of tracking and predicting growth, making it a valuable metric for anyone looking to understand the true rate of return on their investments.
FAQs
What is CAGR in banking?
The Compound Annual Growth Rate (CAGR) measures the annualized return of an investment, though it’s more commonly applied to mutual funds and stocks than banking products. In banking, annualized yield is typically used instead of CAGR, as it represents the interest earned over a year relative to the total investment.
What is the difference between XIRR and CAGR?
CAGR is most accurate for one-time investments, whereas XIRR (Extended Internal Rate of Return) is better suited for investments made periodically, such as through a Systematic Investment Plan (SIP). Since SIPs involve multiple investment tenures, XIRR aggregates different CAGRs to provide a more accurate return for cumulative investments over time.
What is CAGR in economics?
In economics, CAGR reflects the average annual growth rate of an investment over a period longer than a year. It is a reliable way to assess returns on individual assets or portfolios, particularly when performance fluctuates over time.
What is the difference between CAGR and annualized return?
An annualized return is the standard return calculated as a percentage per year, typically extrapolated to reflect a full year. The formula is:
CAGR, on the other hand, shows the average annual growth rate of investments, smoothing out year-to-year fluctuations.
What is the CAGR ratio?
The CAGR ratio represents the geometric progression of an investment's growth over time, making it a widely used metric for comparing different investment returns. It is calculated as:
CAGR = [(Ending Value / Beginning Value)^(1/n)] – 1.
A higher CAGR ratio indicates a better-performing investment over time.
What is the difference between CAGR and rolling returns?
Rolling returns measure the average annualized return for a specific period across various points in time, reducing biases that might come from looking at returns for a single point. While rolling returns capture volatility, CAGR smooths out performance, masking year-to-year fluctuations.
†Policybazaar does not endorse, rate or recommend any particular insurer or insurance product offered by any insurer. This list of plans listed here comprise of insurance products offered by all the insurance partners of Policybazaar. The sorting is based on past 10 years’ fund performance (Fund Data Source: Value Research). For a complete list of insurers in India refer to the Insurance Regulatory and Development Authority of India website, www.irdai.gov.in
Past 10 Years' annualised returns as on 01-11-2024
^The tax benefits under Section 80C allow a deduction of up to ₹1.5 lakhs from the taxable income per year and 10(10D) tax benefits are for investments made up to ₹2.5 Lakhs/ year for policies bought after 1 Feb 2021. Tax benefits and savings are subject to changes in tax laws.
*All savings are provided by the insurer as per the IRDAI approved insurance plan.
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^^The information relating to mutual funds presented in this article is for educational purpose only and is not meant for sale. Investment is subject to market risks and the risk is borne by the investor. Please consult your financial advisor before planning your investments.
#The investment risk in the portfolio is borne by the policyholder. Life insurance is available in this product. The maturity amount of Rs 1 Cr. is for a 30 year old healthy individual investing Rs 10,000/- per month for 30 years, with assumed rates of returns @ 8% p.a. that is not guaranteed and is not the upper or lower limits as the value of your policy depends on a number of factors including future investment performance. In Unit Linked Insurance Plans, the investment risk in the investment portfolio is borne by the policyholder and the returns are not guaranteed. Maturity Value: ₹1,05,02,174 @ CARG 8%; ₹50,45,591 @ CAGR 4%
¶Long-term capital gains (LTCG) tax (12.5%) is exempted on annual premiums up to 2.5 lacs.
**Returns are based on past 10 years’ fund performance data (Fund Data Source: Value Research).
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