How to calculate CAGR?
To understand the calculation, let’s take a scenario:
- Amount invested: ₹20,000
- Investment period: 5 years
- Value after 5 years: ₹30,000
The CAGR formula is:
CAGR = (Final Value / Initial Value)^(1 / Number of Years) − 1
Now, based on our scenario and the formula,
CAGR = (₹30,000/₹20,000)^(1 / 5) − 1
This gives a CAGR of approx. 8.45%. So what does this mean? It means that your investment grew at an annualised rate of 8.45% over the 5 years of your investment period.
What is the importance of CAGR?
CAGR helps in comparing investments when their starting amount and investment period are the same. For example, suppose you put ₹20,000 in two different mutual fund schemes for 5 years:
Fund B ended with a higher value and also has the higher CAGR. In this example, CAGR gives you a common annualised figure to compare the growth of the two investments.
You can also calculate CAGR for the same mutual fund over different periods. This can help you see how its annualised growth looked over, say, 3 ot 5 or 10 years.
Still, CAGR only tells you about the growth between two points. When comparing mutual funds, it also helps to look at the fund’s strategy, benchmark, risk and performance across different market conditions. For that, you can use other methods such as rolling returns or trailing returns.
CAGR vs XIRR: What’s the difference?
The main difference between XIRR and CAGR comes down to how you invested your money. CAGR is generally used when you invest a lump sum at one point and then look at its value later. XIRR is useful when there are several cash flows happening on different dates, such as with a SIP.
For example, if you invested ₹1 lakh once and checked its value after 5 years, CAGR can be used. If you invested ₹5,000 every month through a SIP, XIRR is generally more appropriate because each instalment was invested on a different date.
What are the limitations of CAGR?
CAGR is useful, but it only gives you part of the picture.
- It hides the year-to-year journey: CAGR gives you one number for the entire period. It won’t tell you whether the fund has a smooth ride or went through large ups and downs along the way.
- It isn’t suitable for multiple cash flows: CAGR is designed around a single starting investment and a final value. If you have made several investments at different times, such as through a SIP, XIRR is generally more suitable.
- A past CAGR doesn’t predict future returns: A fund that delivered a high CAGR in the past may perform differently in the future. Market conditions, interest rates, company earnings, and other factors can change.
- It doesn’t measure risk: Two funds can have similar CAGRs while taking very different levels of risk. So, don’t look at the return figure alone. Volatility and drawdowns can tell you more about how much the investment fluctuated along the way.
When should you use CAGR?
CAGR can be useful when you want to:
- Check the long-term growth of a lump-sum investment.
- Compare the annualised growth of two investments.
- Understand how an investment has grown over several years.
- Compare a mutual fund’s performance over different time periods.
For a fair comparison, always compare funds over the same period and using the same calculation method. If you’re investing through SIPs, don’t rely on CAGR alone. XIRR can give you a more appropriate return figure as it considers the timing of each instalment.
The bottom line
Understanding what is CAGR in mutual funds helps you evaluate your mutual fund investment in a better way. It tells you the annualised growth of your investment over time. But don’t treat it as the complete picture. A mutual fund can have a good CAGR and still experience large ups and downs.
If you’re just starting out, use CAGR to understand long-term growth. But at the same time, also look at the fund’s risk along with consistency. And if you’re investing through SIPs, XIRR is generally a better way to measure your returns.
