Using a compounded annual growth rate (CAGR), it is possible to compare the relative profitability of firms over a long period of time. CAGR is typically used to compare the performance of a firm over a period of time, such as sales, revenue, profits, and so on, to that of other companies. So, what is CAGR in mutual funds? We have discussed the intricacies of CAGR and its relationship with mutual fund returns. Let’s get started.
What is CAGR in Mutual Funds?
There is no guarantee that you will get the same rate of return each year if you invest in a mutual fund. Returns might fluctuate depending on market circumstances. It's crucial to know how much money a mutual fund returns since it helps you plan your future investments. CAGR may be used to quantify this.
Over a set period of time, the CAGR lets you see how much your investment has increased. In other words, it's the percentage of compounded annualized returns that you've reaped from your investment over a given period of time.
For example, let's say you put in Rs. 1,00,000, and it rose to Rs. 2,20,000 in six years. Absolute return, which is just the per cent return regardless of the length of time the money was invested, is a common calculation.
There is a return of 120 per cent in this situation, which is equal to (220000-100000)/100000 That identical investment has a CAGR of 17.08 per cent. In other words, the CAGR will keep changing as long as the final and invested values are the same, but the absolute return will stay constant. Let's have a look at how the CAGR meaning is translated into a formula.
How to Calculate CAGR in Mutual Fund?
Here is the formula for calculating the CAGR of a mutual fund investment:
CAGR = (End Value / Beginning Value) ^1 / n – 1
The majority of investors use absolute returns to evaluate their assets' success. However, it does not take into account the worth of money over the long term. However, CAGR takes into consideration how long you've invested in a certain investment opportunity. If there is no volatility, it provides you with an estimate of how much your investment would rise.
It's a great technique to account for the asset's change over a certain time period. Then, you'll be able to see how it performs on a certain horizon. If you're interested in how well your money was spent, this is a great way to do so.
Key Points to Remember about CAGR
- The CAGR is not a measure of sales growth over the course of a certain period of time. Growth may be focused on the first or last year of a project.
- Investments with the same rate of return may be more profitable than others. This might be due to the fact that one's development was faster in the first year, while the other's increase occurred in the last year.
- For investment durations of three to seven years, they often use CAGR. CAGR may obscure the interstitial patterns if the period is longer than, say, 10 years.
- Keep in mind that CAGR (Compound Annual Growth Rate) is not the same as the annual growth rate.
Relationship Between CAGR and Mutual Funds
As an investor, you must choose whether or not a mutual fund is worth your time and money. To do so, you'll need a way to track its performance over time. A mutual fund fact sheet would show the fund's growth rates across a variety of time periods. It may be difficult to evaluate the fund's success based on a variety of returns.
Instead, if you were able to track its growth over time, things may be a lot easier. It's here that the CAGR comes in handy since it provides a single yearly growth rate. In addition, compound interest comes into play.
Compound interest is used to calculate returns in the majority of investment options, including mutual funds. As a result, the compound annual growth rate would be an appropriate metric to use when assessing the performance of a mutual fund.
Advantage of CAGR
The compound annual growth rate (CAGR) is one of the most often used metrics to assess an investment's long-term profitability. Market metrics, as well as other considerations, are taken into account when calculating short-term CAGR.
A long-term CAGR eliminates any short-term changes, since the security soon recovers from such market shocks, allowing investors to assess the underlying potential of such firms.
Limitations of CAGR
1. Doesn't take into account the volatility of the market.
CAGR is a measure of stock or company variable growth that assumes no other influences are present. That's a glaring omission that has a long-term impact on the success of publicly traded corporations. Even though the yearly return rate of securities varies, CAGR takes into account the average of all returns.
2. For risk evaluation, this isn't optimal.
It is difficult to tell how a stock market instrument performs when it is subjected to high changes since CAGR does not represent the volatility of a securities transaction. The CAGR of a firm does not take into consideration short-term fluctuations in the behaviour of securities, and therefore, it cannot be used as a measure of a company's performance. In order to accurately anticipate the performance of a stock market instrument, other technical analysis methods should be used in conjunction with each other.
3. Return on invested capital
IRR employs discounted cash flows and net present value to estimate a company's profitability. High returns may be achieved by investing in equities that have a higher anticipated internal rate of return than expected.
As a popular analytical tool among investors, compounded annual growth rate does not give a full view of all related hazards, even though it is one of the most often used. However, long-term CAGRs of numerous underlying criteria reveal a company's growth pattern and the company's future potential for growth.
Despite its usefulness, the CAGR does not convey the full picture when evaluating investment possibilities. The CAGRs of investment options may be compared to see how they stack up against one other over time. Investors, on the other hand, must take into account the proportional risk of their investments. An additional metric, such as standard deviation, is needed for this.