Investing is integral to growing your wealth. Measuring the growth of your investment is equally crucial as it can guide you to adjust your strategy to align with your goals. But, how do you measure the growth of an investment accurately? That’s what Compound Annual Growth Rate (CAGR) is for–a widely used metric that, factoring compounding, measures the annual growth of an investment. Whether you’re investing in mutual funds, shares, or fixed deposits, CAGR can help you assess the true growth of your investment. 

How Is CAGR calculated? 

The formula to calculate CAGR is (FV/PV​)1/n​−1. Here, ‘FV’ is the final value of the investment, ‘PV’ is the initial value of the investment, and ‘n’ refers to the number of years (or periods) the investment has been held for. For example, you have invested Rs.1 lakh, which grows to Rs.1,40,493 in three years. The CAGR for this investment would be (100000/1,40,493)1/3 −1, which is 12 per cent. As you can see, it provides a clear picture of your investment’s annual growth, making it easier to assess its performance and determine if it has outpaced inflation over time. 

Why Use CAGR Over Simple Returns?

CAGR reflects the effect of compounding on your investment’s performance, making it more accurate than simple returns. If you reinvest your profits, your money grows faster over time and CAGR accounts for this, but simple returns do not.

What CAGR Does Not Tell You

While CAGR is useful, it has its limitations. CAGR does not show market fluctuations or risks. For example, investment A might grow steadily over three years, but investment B may go through significant ups and downs before achieving the same CAGR as investment A. This makes CAGR less suited for irregular investments like Systematic Investment Plans (SIPs) as compared to Extended Internal Rate of Return or XIRR. 

The CAGR of an investment is a crucial metric which can help you set realistic goals. For example, if you want an investment that doubles your capital in six years, you’d require it to have a CAGR of approximately 12 per cent. And, by understanding how compounding works, you can make investment decisions that align with your goals.

Difference Between CAGR And Compound Interest

In matters of investing, CAGR and compound interest hold significance. They can help you understand how your investments grow over time. Understanding the difference between them is an important step towards making informed financial decisions. There is a difference in how these two are applied to investments. Here’s how. 

Details

CAGR (Compound Annual Growth Rate)

Compound Interest

Definition

Measures the annual growth rate of an investment over time, showing the effect of compounding.

Represents the interest earned on the initial principal plus previously accumulated interest.

Purpose

Helps evaluate and compare the performance of investments like mutual funds, stocks, or portfolios.

Used for calculating the growth of fixed deposits, savings, and the cost of loans.

Flexibility

Gives a single annualised growth rate, smoothing fluctuations over time.

Accounts for various compounding frequencies like daily, monthly, or yearly.

Suitability

Best for long-term investments where returns are not fixed but vary over time.

Ideal for fixed-income instruments or debt obligations with predictable returns.

Relevance in India

Popular for analysing mutual fund performance and wealth-building strategies.

Widely used for determining fixed deposit returns, savings growth, and loan repayments.

 

CAGR is a simple yet powerful tool for tracking the growth of your investments. When comparing investments, don’t limit yourself to only checking the returns, also calculate the CAGR to understand how your money is really growing. When it comes to investing, knowledge is power. The more knowledge you have about how various aspects of investing work, the better equipped you will be to make your money work harder for you. 

The author is the DGM Communication of BankBazaar.com. This article has been published as part of a special arrangement with BankBazaar.