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Why CAGR And Market Linked Investments Don't Go Together

Writer's picture: Akshay NayakAkshay Nayak

Compounded Annualised Growth Rate (CAGR) is one of the most popular investment metrics. It is generally used to evaluate and compare returns from different investment products over a certain period of time. CAGR is most commonly used to evaluate the performance of market linked investment products. But in truth, the concept of CAGR has no applicability when it comes to market linked products.


So what then is CAGR? Where is the concept applicable? Why is it not applicable to market linked investments? And if such is the case, how do we evaluate the performance of our portfolios over time? These are the questions that I will try to answer in this post. I will begin by talking about the concept of CAGR and its applicability. I will then talk about how portfolio performance can be evaluated without the use of CAGR.


Concept And Applicability Of CAGR


Compounded Annualised Growth Rate (CAGR) measures the return of any investment avenue that offers a compounded return. In other words the return from the avenue being considered must be constant and cumulative. The fact that CAGR considers compounding over time makes it a better measure for performance evaluation relative to absolute returns.

CAGR can be applied to evaluate the return of avenues such as a fixed deposit. In case of fixed deposits, the amount invested and interest rate earned remain constant. Interest is earned on the cumulative balance available in the deposit after each compounding interval. Therefore the standard compound interest formula A = P (1+r)^n represents the CAGR of the fixed deposit over its tenure.


Why Is CAGR Not Relevant To Market Linked Assets?


CAGR can be applied to an investment avenue where returns returns are both cumulative and constant. Returns from market linked assets are cumulative. But they are almost never constant. Investments in market linked assets are usually made systematically. This means additional investments are made after the initial investment during the period where we invest. Withdrawals may also be made during the investment horizon.


CAGR ignores volatility in returns. It also does not account for additional investments and withdrawals made during the investment horizon. These two major drawbacks of CAGR make it irrelevant for use with market linked assets. At best, CAGR is an arbitrary definition to represent the growth of an investment where returns are variable. CAGR represents the overall growth of a market linked asset during the investment period. It does not mean that a market linked asset has grown at a constant rate year on year.


For instance, say an investment of Rs 1,00,000 in a Nifty 50 index fund has generated a CAGR of 10% over 5 years. This means that the investment grows to a value of Rs 1,61,051 after 5 years. The statement that the investment has grown at 10% CAGR creates an impression that a graph of the investment's value would be similar to the graphic below.

But such a graph is actually representative of an investment avenue that offers linear returns. Returns from market linked instruments are always variable. A more realistic representation of the value of a market linked investment would be similar to the graphic shown below.

Using CAGR to measure returns from market linked investments does not therefore reflect the volatile nature of the returns. Therefore CAGR is not a realistic means to measure returns from market linked investments. There is a case to be made (at least in theory) that CAGR can be used as a comparative measure. But in practice, there is very little substance to this claim.


Say for instance that the Nifty 50 has a 10 year CAGR of 10% and ABC Mutual Fund has a 10 year CAGR of 12%. In theory this implies that ABC Mutual Fund has beaten the Nifty 50 by 2% over 10 years. In practice though, this inference is irrelevant. It must be remembered that CAGR is calculated in hindsight.


This means that CAGR is calculated on the basis of historical returns. But we invest in the present to provide for the future. Inferences gained on the basis of past returns would therefore be of very little relevance to us. We therefore need a method of evaluation that allows us to track the performance of our portfolios in real time. That would give us a realistic understanding of how our portfolios are growing.


If Not CAGR, Then What?


The ultimate objective of planning finances is to ensure that we have enough money for our goals when they fall due. Therefore it the actual value of the portfolio that matters more than the rate of return. The most realistic way to evaluate the performance of our portfolios would therefore be to track their value over time. When evaluating the portfolio for a goal, the key questions to ask ourselves are as follows :


A. How much money do I need for this goal?


B. What is the Current Market Value (CMV) of the portfolio built for the goal?


C. Does the CMV of the portfolio leave me with enough money to meet the goal?


D. If not, what is the value of the gap that needs to be provided for?


E. What is the value of the annual and monthly investment required to fill the gap?


These questions can be incorporated into a simple calculation as shown in the graphic that follows :

The key inputs here include the current cost of the goal, CMV of the portfolio and the years to goal. The key outputs are the annual and monthly investment amounts required. This calculation can be carried out once a year. Updated values may be taken for the key inputs each year. This allows us to account for :


A. Inflation in the cost of the goal


B. Growth in the market value of the portfolio


C. Reduction in the investment horizon of the goal.


The key inferences that can be drawn from this calculation include the following :


A. If the value of the gap to be funded = 0, it means we have enough money for the goal. No further investments would be required for the goal in the current year. The adequacy of the amount available would need to be reviewed annually until the goal falls due. Additional investments may be required for the goal during future years on the basis of the annual reviews.


B. If the value of the gap is greater than zero, we must look at the required monthly investment amount. If this amount is within our monthly saving capacity, it means that we are on track to achieve the goal. It also shows that our portfolio is growing adequately. And if such is the case, the rate of return from the portfolio is irrelevant.


If the required amount is more than our saving capacity, it means we need to invest more for the goal. It may also imply that our portfolio has not grown as expected during the current year. The additional amount of savings required may be generated by increasing income or reducing expenses. This reduces our dependence on returns from the portfolio.


The method described above represents a much more realistic way to evaluate the performance of our portfolios. Performance evaluation would happen in real time on the basis of actual figures. The need to make assumptions about inflation and rates of return from the portfolio is negated. Theoretical inferences from comparisons made on the basis of past returns would not be required.


The issue with CAGR therefore does not stem from the concept itself. It stems from the way it is wrongly used and interpreted. The financial services industry will continue to use CAGR to measure and compare returns from market linked investments. But as seen today, CAGR returns are at best an approximate measure of growth. And they based on theoretical inferences and historical returns. Therefore it is important for us to not read too much into CAGR returns. The focus should actually be on the growth in the value of our portfolios. This would give us a realistic perspective on which to evaluate the performance of our portfolios.

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Disclaimer : The information given in all articles on my blog Finance Made Fun For Everyone is meant for educational purposes only. None of the information given in any of these articles must be construed as investment advice. Readers are advised to act on information they find in this blog at their own discretion after adequate due diligence. 

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