Compound Annual Growth Rate is the average annual growth rate of securities or portfolio over a period of time. This is often used by the asset management companies to demonstrate the rate of returns posted by the funds they manage.
It is considered to be one of the best ways to ascertain the rate of return on investment over a period of time. In other words, the investors get to know what they stand to receive at the end of the investment period when the investment gives an annualised yield at this rate.
When you want to compare the rate of returns of one fund against its rival funds or against the market index, CAGR is a great tool. It works best when you compare multiple funds during a specified period, and not for different time periods.
How is it calculated: To calculate the CAGR, you have to compute the ‘rth’ root of a value ascertained by dividing the final value of investment by the initial investment. And deduct ‘1’ from the final value.
So, the formula becomes CAGR = (Final value/ initial investment)1/r – 1, where, ‘r’ is the number of years for which the investment was held.
For example, when you invest ₹1,000, it rises to ₹2,000 after one year and at the end of second year, it declines to ₹1,500. Here, r = 2
To calculate CAGR, you have to find the square root of (final value/ initial value) = (1,500/1000)1/2
= (1.5)1/2 – 1
= 1.2247 – 1
= 0.225
= 22.5%
However, CAGR also has its limitations. Since the CAGR reflects a ‘smoothed’ rate of return, it doesn’t show volatility in the stock or portfolio during one part of the period. Although, it gives an impression that there was a consistent rate of return, but during that time period, the portfolio may have fluctuated in both directions.
To accurately measure volatility, one can use standard deviation, which shows the deviation from expected return. So, if there is a high volatility, the standard deviation during that period would be high.
On the other hand, the less volatile return would have a low standard deviation. At the same time, when there is no change in the rate of return in a particular year, the standard deviation would be zero.
So, we can conclude that the CAGR is an effective tool to measure the rate of return of an investment. But it is not a fool proof measure. To accurately measure the return shown by the CAGR, one must compare the CAGRs of the same time period. Also, to capture volatility during the time period, one can use standard deviation.