Compound Annual Growth Rate or CAGR is one of the most important concepts that investors must understand to build long-term wealth. Understanding the CAGR of various investment instruments allows investors to compare investments in a more standardised manner and make informed financial decisions. In this article, we will take a look at what the Compound Annual Growth Rate (CAGR) is and how you can use it to build your wealth in the long term.
What is CAGR (Compound Annual Growth Rate)?
Compound Annual Growth Rate or CAGR is the mean annual growth rate of an investment instrument over a period of time longer than one year. When calculating CAGR, profits are assumed to be reinvested, so it also considers the annual compounding effect while providing the rate of growth. It is one of the most accurate and widely accepted ways to calculate the long-term annual returns from any investment.
In mathematical terms, CAGR is a formula that helps derive the annual growth rate of an investment compounded over many years. The formula for CAGR is as follows:
CAGR = (Ending Value / Beginning Value)^(1/n) – 1
Where ‘n’ = number of years.
While the mathematics might seem complex, the concept is simple. CAGR removes the volatility in returns over time, providing an average of an investment’s annual performance over time.
Let’s understand with the help of an example. Suppose you invest ₹1,000 in 2020. In the year 2021, the value of your investment grows to ₹2,000 but falls to ₹1,500 when 2023 rolls around. In this case, your investment went up by 100% in the first year and fell by 25% in the second year. Applying the CAGR formula gives the compound annual growth rate of 22.47% for the investment considering the returns are reinvested. Thus, it can be said that this investment grew at a CAGR of 22.47% annually. As mentioned, the CAGR formula helps smooth over volatility to offer an average figure of the investment’s growth.
How can CAGR help in long-term wealth creation?
Understanding CAGR can serve as an important financial tool when it comes to long-term financial planning. Whether you want to save up for a down payment towards a house or to save for your children’s college education, CAGR can help determine the potential value of your investment over the next few years. There are many online financial calculators available that can help you use CAGR to determine the projected value of your investments in the future.
By harnessing the power of compounding offered by CAGR, investors can compare the returns of various investments and then make informed decisions about where they wish to invest their money for long-term growth and wealth building. Understanding CAGR can also help investors determine how much money they would need to invest year-on-year to reach their desired financial goal.
Let’s understand with the help of an example how CAGR over the long term can help you build wealth. Consider you invest ₹10,000 in a mutual fund that grows at a CAGR of 12% for 20 years. At the end of 20 years, the value of the investment would grow to about ₹96,000. That’s almost 10 times the original investment.
To conclude
Understanding CAGR equips you with the financial knowledge and foresight needed to make the right investments at the right time to grow your wealth over a long period of time. It can help you plan for important financial milestones and compare different instruments to decide which is the best investment choice for your needs. However, CAGR only offers a compounded average annual growth rate, and it fails to realistically show the risks involved in investments, especially in the short term. To understand CAGR in more detail, consider consulting with a financial advisor.