Compound Annual Growth Rate (CAGR) Formula and Calculation

When you invest your money in a fixed deposit, you figure out how much you will invest, look for the best interest rates, and estimate your returns over a tenure. After all, it helps to know how much you will gain before locking your money in. So, why shouldn't you be as well-informed while picking a mutual fund?

Mutual funds are heavily dependent on market fluctuations, so it isn't as straightforward to anticipate their returns as you can with fixed deposits. But don't worry! You can estimate a mutual fund's returns using a metric called Compound Annual Growth Rate (CAGR).

If you have ever browsed mutual fund schemes, you will notice 'CAGR' written on your screen, along with a percentage value. What does this term mean to you, as an investor? Here is everything you need to know.

What is CAGR in mutual fund?

CAGR indicates how your investment's value grows over a period of time. In other words, it shows you approximately how much your investment has earned each year over a given time interval.

CAGR is not the same as the annual growth rate of your investment. The annual growth rate is a simplistic, absolute value that indicates your mutual fund's performance over a year.

On the other hand, CAGR depends on the total investment period. While calculating a CAGR, it is assumed that the same growth rate was compounded each year for the entire duration of your investment.

To understand this better, let us look at how CAGR is calculated. Later in the article, we will also compare CAGR and annual growth rates.

Additional Read - How are Mutual Funds Returns Calculated?

How does CAGR Work?

Compound Annual Growth Rate is an extremely useful tool because it smooths out the fluctuations in investment returns that occur from year to year. This is because investments don’t grow at a consistent rate. Some years might see big gains, while others might have slight losses. Instead of focusing on these yearly changes, CAGR averages them out and gives you a single growth rate, making it easier to compare different investments.

The Compound Annual Growth Rate (CAGR) formula is as follows:

CAGR= (final value/initial value)^(1/n)-1

Here,

'final value' is the value of your investment at the end of the investment period

'initial value' is the value of your investment at the beginning of the investment period

'n' is the number of years for which you have invested

Suppose you invested Rs. 20,000 in a mutual fund scheme. After five years, your money grows to Rs. 36,000. Let us calculate the CAGR:

CAGR = (36000/20000)^1/5 - 1 = 12.47%

Simply put, your investment in the mutual fund has given you an average return of 12.47% every year.

One key feature of CAGR is that it accounts for compounding. When you get returns on your original investment, those returns are reinvested, and you start earning returns on them as well. This accelerates the growth of your investment. Because of this compounding effect, CAGR is a more accurate measure of your investment’s true growth compared to simple averages, which don’t reflect the reinvestment of earnings.

How is CAGR used in mutual funds?

Mutual fund performance over periods longer than one year is typically shown as the Compound Annual Growth Rate (CAGR). AMCs provide CAGRs for 1-year, 3-year, 5-year, and since inception in their monthly fund factsheets.

It's important to note that CAGR is only used for point-to-point returns and is not applicable to investment plans like SIPs, STPs, or SWPs. Despite this limitation, CAGR is a useful tool to assess a fund's overall performance.

By comparing CAGRs across various funds, you can make more informed investment choices.

CAGR vs annual growth rate

Let us assume that your mutual fund's growth looks like this:

As an investor, if you gauge the worth of the fund with the annual growth rate between 2017 to 2018, you may think that the fund is performing poorly. But, looking at the 5-year CAGR, you can see the average yearly growth rate of your investment, which is 12.47%.

For investors, the CAGR is a more detailed and accurate metric. So, before you invest, use a CAGR calculator for mutual funds.

Additional Read - What Are the Average Returns on Mutual Funds?

In conclusion

CAGR is a valuable tool for investors as it provides a clear and accurate picture of how an investment has grown over time. Unlike annual growth rates, which may fluctuate, CAGR smooths out these variations, offering a single, consistent growth rate. This makes it easier to compare different mutual fund schemes and assess their long-term performance.

By factoring in compounding, CAGR reflects the true growth of your investment, making it a more reliable metric than simple averages. Understanding how to use CAGR effectively can help you make informed investment decisions and better evaluate potential returns.

Are you ready to generate wealth with mutual funds but don't know where to start? Tata Capital's Moneyfy App is the solution for you.

Set a financial goal, assess your risk profile, and pick from recommended mutual funds. Download the app today.

FAQs on CAGR

Why is CAGR important?

CAGR provides a smoothed annual growth rate over a specified period, accounting for compounding. It offers a clear picture of an investment's performance, eliminating the effects of volatility, and allows for easy comparison between different investments.

What is a good CAGR percentage?

A good CAGR depends on the type of investment and market conditions. For stocks, a CAGR of 7% to 10% is generally good for long-term growth. To keep up with inflation, aim for a CAGR of 4% to 5%. If your CAGR is lower than inflation, your money’s buying power may decrease.

What is the CAGR return in mutual funds?

In mutual funds, CAGR indicates the annualised return, assuming profits are reinvested. It reflects how an investment grows over time, smoothing out short-term fluctuations, and provides a clear measure of a fund's performance.

When to use CAGR?

Use CAGR to assess investment performance over periods longer than a year, especially when comparing different investments or tracking growth. It's particularly useful for evaluating the performance of assets with volatile returns, as it provides a smoothed growth rate.