When it comes to personal finance management, we often gets confused, with different terms and calculation. Any investor always aim at getting a higher return on their investment, but unable to determine the various factors to choose an option. However, if we want to know how an investment has grown or is likely to grow every year over several years, a good indicator is the CAGR.
Compound Annual Growth Rate (CAGR) is a financial metric that calculates the average annual growth rate of an investment over a set period of time. It is used to evaluate an investment's sustainable growth and relative profitability. CAGR is calculated using the following formula:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1
FV = is the future value
PV = is the present value
n = is the number of years
CAGR takes into account compounding, which is when earnings from previous periods are reinvested to contribute to future growth. It's considered one of the most accurate ways to calculate returns for anything that can rise or fall in value over time.
To evaluate, how it is working, Here is an example of how CAGR works:
If we invested Rs 10,000 in a mutual fund and it grew to Rs 15,000 after five years, the CAGR would be approximately 24.46%. This means that our investment grew by an average of 24.46% annually over the five-year period.
CAGR can be used to compare the performance of two or more investments over time. However, it doesn't reflect investment risk. CAGR is helpful because it allows investors to easily compare the long-term performance of different investments option. Even if the markets have experienced varying levels of volatility, CAGR helps in providing a standardized metric to assess performance and make informed decisions when comparing various investment options.
Key benefits of using CAGR:
CAGR enables direct comparison of different investment options, even if they have different investment periods, allowing investors to choose the one with the most consistent growth.
By averaging out short-term volatility, CAGR provides a more accurate representation of an investment's long-term performance, helping investors assess its true potential.
CAGR can be used to project future growth of an investment, allowing investors to plan for future financial goals and make informed decisions about their portfolio allocation.
CAGR is a crucial metric for evaluating the performance of mutual funds, stocks, or any other investment over a set period, helping investors gauge whether their investments are meeting expectations.
While not directly measuring risk, a consistently positive CAGR over a long period can indicate a relatively stable investment with lower volatility.
While not a guaranteed prediction, CAGR can be used to estimate the potential future growth of an investment based on its past performance, assuming similar growth patterns continue. This is what makes it a valuable tool for decision making and strategic planning when it comes to investment.