There are several metrics that can be used to measure the performance of your investments. One of the most reliable and widely used methods to measure the performance of mutual funds or any other investment is the Compound Annual Growth Rate (CAGR). Understanding CAGR can help investors make better decisions and get better long-term returns by accurately comparing the returns on various investments. In this article, we will take a look at why CAGR is a crucial metric for evaluating the performance of mutual funds.
What is Compound Annual Growth Rate (CAGR)?
Compound Annual Growth Rate or CAGR is the average annual growth rate of an investment measured over a long period of time (more than a year), which assumes that profits are reinvested at the end of each year, so compounding is factored in. CAGR smoothens the returns over the entire investment period, which makes it simpler for investors to understand the actual performance of mutual funds.
The formula for calculating CAGR is as follows:
CAGR = (Ending Value / Beginning Value)^(1/n) – 1
Where ‘n’ = number of years.
Let’s understand with the help of an example. Suppose you invest ₹10 lakh in a mutual fund that grows to ₹20 lakh after 5 years. However, the growth may not be consistent. During a certain year, you may end up with 30% growth, and during another year, you may face a 10% loss. However, CAGR takes the total growth over the years into consideration and smooths out these fluctuations between individual years, thus offering a standard percentage view of annual growth. Thus, the CAGR of this mutual fund investment is 14.87%.
Why is CAGR the best metric to measure mutual fund performance?
Here are the main reasons why investors should be using CAGR to measure mutual fund performance:
- Easy comparison: CAGR offers a standardised way of understanding the long-term returns offered by various mutual funds, which makes it easier for investors to compare the returns offered by various mutual funds. Ultimately, it can help investors make an informed decision about their future investments.
- Set realistic goals: In case you are investing to save up for a specific financial goal, CAGR can help you calculate how long you will need to invest in order to reach your desired amount considering the returns offered by mutual funds. Moreover, you can also use a CAGR calculator to understand how increasing your investment can help you achieve your financial goals faster.
- Offers a realistic view of long-term performance: The stock market can fluctuate wildly in the short term. However, looking at the short-term performance fails to capture a realistic performance of the mutual fund. By considering the CAGR of the mutual fund over a long period of time, investors can get a more realistic idea of the returns.
To conclude
CAGR is an invaluable metric for investors, as it offers a simple and standardised way to measure and compare mutual fund performance. It allows investors to look at the bigger picture and make informed investment decisions about the future. Most importantly, considering CAGR can help individuals make realistic investment plans to reach important financial goals.
