CAGR stands for Compounded Annual Growth Rate. It is the growth rate that your initial investment would need to experience to grow to a set level over a specified period of time. It is analogous to compound interest. An investment or an investment portfolio will experience different rates of return over different periods. For example, your portfolio might experience a large gain one year, a smaller gain the next year, and a slight loss in another year.
CAGR allows an investor to calculate their portfolio’s returns over a period of years: say, five years. It filters out the year-to-year “noise” in returns to help the investor figure out how their investments have done over a set period of time. This can be useful in helping them compare their results to other investments or a benchmark index.
The formula for CAGR is:
Divide the ending value of the investment by the beginning value of the investment for a certain time period.
Raise the value calculated in the first step by an exponent of 1 divided by the number of years you are calculating the CAGR for.
Subtract 1 from this result.
Let us understand with an example
Suppose a person invested Rs. 12000 in a mutual fund on Jan 01, 2015 and redeem it on Jan 01, 2020. The value of the investment at the time of redemption was 25000. So here CAGR (Compounded annual growth return turns out to be)
Formula to calculate CAGR
CAGR = {(25000/12000)^(1/5)}-1 = 10.76%
Here we have assumed that investment is done only at the beginning and also redeemed only once. In between these 5 years, no investment is made at nothing is redeemed. So CAGR easily turns out to be 10.76%
But there are sometimes when investment is not made at lumpsum but made periodically. So at that time CAGR turns out to be an irrelevant method to calculate return.
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