What is it?
Compounded annual growth rate, or CAGR, is a way to calculate long-40+ term returns. There are two ways of calculating your income from an investment over a period of time—simple interest and CAGR.
What does it mean?
CAGR takes the first and last points of investment to calculate returns. It also accounts for the time period you remain invested. Say, you invest Rs10,000 on 1 June 2007. On 31 December 2009, your investment grows to Rs20,000 and you want to sell your investment. You have stayed invested for around two-and-a-half years.
Ordinarily, you would think that your money has doubled, so your return would be 100%. But as per the CAGR, your returns are 26%. That is your money grows by 26% per year over the period of investment.
How is it different from simple interest?
Simple interest does not account the time period. So Rs10,000 growing to Rs20,000 after one year or, say, 10 years, would still show a growth of 100%. As against that, a CAGR would show a different figure for different time periods because it accounts for the period over which you’ve stayed invested. This is why, CAGR is used to calculate returns if the time period exceeds a year. This is also why returns calculated using the CAGR method are lower than returns calculated using simple interest, if the time period is more than a year.
What is its downside?
CAGR does not capture volatility. In our example, if in 2008 the value would have gone down, CAGR would not have captured that. Compound interest smoothens up the returns over a period of time. Also, it’s important to ensure that when you compare CAGR returns of two or more investments, the time period is the same. Ignoring the time period when comparing CAGR returns would distort the picture.