Getting introduced to investments is like entering into a world of financial benefits, you discover how your money can make more money, not just be used for purchasing products and/services. Well, running a business also involves that, but investments are easier and can be availed by anyone. The most basic of investments start with a fixed or recurring deposit, and investments can be as extensive as putting your money into companies, stocks, or bonds. Wealth building through investments happens through the returns achieved. Compound annual growth rate, or CAGR is one of the most accurate ways to find out the value of such returns. It can be used to determine the returns for individual assets, investment portfolios - practically anything that can rise or fall in value over time.
In the words of Albert Einstein - “Compound interest is the eighth wonder of the world. He who understands it, earns it... He who doesn’t...pays it. CAGR helps provide a smoothed rate of return. In other words, it is really a pro forma (using projections or presumptions) number that tells investors about investment yields on an annually compounded basis. That basically translates to an idea of what the investors will have at the end of the investment period.
Let us pick a very simple example. Suppose you invest INR 1000 at the beginning of 2019 and by the end of the year, your investment was worth INR 3000. That is a 200 percent return. In 2020, the market corrected and you incurred a loss of 50%. Thus, at the end of 2020, you end up with INR 1500. So, what was your return on investment for this period?
Calculating the average annual return will not work in this scenario. It will result in 75%(the average of 200% gain and 50% loss). However, in the 2-year period of investment, the investment was worth INR 1500, not INR 3065(INR 1000 for two years at an annual rate of 75%). Here, you need to calculate the CAGR to determine your annual return for the investment period.
You need to calculate the nth root of the total return - n being the number of years the investment was held for. In the example we mentioned earlier, the square root(2 years investment) of 50 percent(total return for the investment period) will lead to a compound annual growth rate of 22.5%. If plotted across a graph of investment period versus the investment returns, one can notice that the CAGR will show the same initial and ending values of an investment, albeit through a very gradual slope, whereas yearly returns might result in a creseries of troughs and crests.
The Investment Perspective
It is important to note that CAGR does not account for risks. The returns are locked in place and CAGR depends on that, thus the year-on-year risks that happen often in investments are not visible in CAGR.
Going just by the CAGR calculations, it might seem that certain investment options are better choices when compared to others. But since the risk is not factored in, it will be playing blind with your investment if you are just going to be led around by CAGR.
So, if CAGR is speculative in nature, what is the practical use for it? An investment firm, while doing financial analysis of any new investment asset, takes into account the past performance of assets in the same market. That provides a rough estimate of how future investments will perform. It helps in providing some amount of credible information to investors while assessing different options. However, make sure that you are made aware of the risks involved in the investment as well. If you are only being provided with the CAGR as a metric, as an investor you can analyse investment alternatives by comparing CAGRs from identical time periods. Make it a point to also learn about investment risk, through the standard deviation for the same assets.