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Annualised Return and CAGR

Annualized return and CAGR are not technically the same thing. They refer to the returns on various investment options computed on per annum basis. All long term investments multiply by your wealth by compounding.

Where investment has grown at different rates over a few years, CAGR is the formula used to define the number at which the investment has grown year on year.

Compounded Annual Growth Rate (CAGR) shows how much a person’s investment grew in one year. In other words, it is the average returns an investor earns on his investments after one year. The bank or the financial institution calculates this rate in terms of annual percentage.

How to calculate CAGR?

To calculate CAGR, you must know the following:

  1. The investment made in the initial year (the year of investment)
  2. Amount invested in the current year and
  3. Tenure of investments

CAGR = [(End value/beginning value)^(1/year)] – 1

Example:

For example, you bought a stock for ₹100 in 2015. It appreciated by 25% to ₹125 in the year 2016 and further appreciated to ₹150 in the year 2017. Therefore, the appreciation in the rate from 2015 to 2017 was 20%.

If you want to know the growth rate of your investments for the complete period of time, use CAGR. If we put the above values in the formula, Compound Annual Growth Rate for your investment between 2015 and 2017 will be 14.47%.

Mutual Funds/Equity and CAGR

Return on any investment is discussed in terms of CAGR. Especially, in case of equity and mutual fund investments. When you invest in mutual funds, the return that is shown in CAS statements and your Dmat statements are in CAGR.

This is because the actual return % on mutual funds is dependent on the movement in the stock market which keeps changing. It never grows or falls at a fixed rate.

Hence, it could be possible that an investment in mutual fund grew at the rate of 20% in year 1, 30% in year 2, 10% in year 3. In such a case, it becomes very difficult to discuss the actual gains. This is when and why CAGR is used in market-related variable returns investments.

In our Article, how to set goals, we have discussed the expected returns on various asset classes, we are always talking about CAGR.

Wealth Cafe Note:

  1. CAGR is an average rate. Hence, if a CAGR is of 15% of an investment made for 4 years. It could be possible that the first 3 years have 30% gains and the next 2 years lower gains.
  2. The gains are not distributed evenly over the period of investments. One must stay invested for the right time based on the asset class to benefit the most.
  3. CAGR is different from absolute returns and year-on-year gains.
  4. There is a chance that two investments may reflect the same CAGR, with one being more lucrative than the other. This could be because the growth was faster in the initial year for one, while the growth happened in the last year for the other.
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What is Absolute Returns ?

If you are making direct investments in various mutual funds or making the same through any portal/website. You could see in the mutual fund statements that a column states absolute return and a % is mentioned next to it.http://www.wealthcafe.in/understanding-a-mutual-fund/

Absolute return is the simplest return metric that is used to quantify how much gain or loss you have made from an investment. It simply tells you how much money you have made or lost as a percentage of the money you invested over a given period of time.

For example – you invested Rs. 100 in 2010 and it became 130 in 2012, your absolute return is 30% for 2 years. It is not a per annum return.

Absolute return is the actual return that you receive for the specific period i.e. from the start to the end.

If you invested INR 10,000 in October 2018 and currently, in Feb 2019, its value is 10,600. The absolute return is 6% on this investment.

Absolute Return = Current Saleable Value – Purchase Value / Purchase Value * 100

Absolute Returns are not used for mutual fund calculations until the investment period is less than one year. The returns can be very misleading. It is mostly used for real estate investments. You must have heard people say that they bought a house in 2000 for 30 lakhs and today in 2019 the value of that house is 1 crore. This is absolute returns of 235%

Why Absolute Returns are not favorable?

It is hard to compare 2 different investments return where the time periods vary: The scope of using absolute return metric to evaluate performance is limited as it does not take into account the time period of investment and its compounding effect. For example, if Fund A gave you 25% return over 2 years and Fund B gave you 25% returns over 1 year, both of them would rank the same if you take the absolute return metric when clearly, one fund has taken longer to deliver the same returns.

It does not allow comparison against various asset classes: Different asset classes returns are generally referred to differently. Real Estate and gold are generally discussed in absolute terms whereas fixed deposits and mutual funds are discussed in annualized returns.

Absolute Return gives a false impression of high worth: Further, because absolute figures are usually high, it gives a false impression of the worth of that investment compared to others. Take the real estate example. The investment in Bombay house which fetched a gain of Rs.70 lakhs does sound grand, and an absolute return of 235% sounds even better. But when we look at the same gains in CAGR terms, it works out to be a modest 6.54%.

Tip – Absolute returns are feel-good returns but they do not give the real gain scenario. In our view, you should always compute the annualized return or CAGR. Refer our Article on the same.

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