Understanding Compound Annual Growth Rate and It’s Benefits
What is Compound Annual Growth Rate?
The Compound Annual Growth Rate is an important metric that measures the average rate of return on an investment over a specified period of time, typically expressed as a percentage. This metric is widely used by investors and financial professionals to evaluate the growth of an investment and compare it to other investments over the sametime period.
CAGR considers both the starting and ending value of an investment and the number of years it has been invested.
It is calculated as follows:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) - 1
For example, if an investor invests ₹ 1 Crore in a mutual fund that grows to ₹2 Crores in 5 years, the CAGR of the investment would be 14.86%. This means that the investment has grown at an average rate of 14.86% per year over the 5-year period.
Benefits of using Compound Annual Growth Rate:
One of the key benefits of using CAGR over absolute returns is that it helps to account for the effects of compounding. Compounding is the process of earning interest on the investment and reinvesting the interest, leading to exponential growth over time. CAGR is hence a better metric for evaluating the growth of an investment over a longer period of time.
Additionally, CAGR helps to smooth out short term fluctuations in an investment’s returns, providing a more accurate representation of its performance. For example, if an investment experiences high returns in one year and low returns in another, the CAGR will provide a more accurate representation of its average returns over the period, as compared to just looking at the absolute returns.
Furthermore, CAGR can be used to compare investments of different lengths, allowing for a fair comparison of investments that have been held for different periods of time. This is particularly useful when comparing investments with different investment horizons, such as a short-term investment versus a long-term investment.