Difference between Absolute Returns and CAGR
The sole purpose of an investment is to earn returns and create wealth. The higher the earning potential of an investment, the better it is. A challenge here is gauging investments correctly to understand the earnings potential. Particularly, when it comes to investments of recurring nature or of a compounding nature. Mutual fund investments are one such investment that requires a thorough understanding of how the earnings are computed. There are absolute returns and there is the Compounded Annual Growth Rate (CAGR).
What Are Absolute Returns In Mutual Funds?
The absolute returns calculation does not consider the period or tenure of the investment during which the returns have been earned. It simply takes into consideration the initial investment amount and the maturity amount.
Absolute returns is calculate as below:
Absolute Returns (%) = (Current Value – (less)Principal Investment)/Principal Investment * 100
Let’s understand this better with an example. If you had invested INR 1,000 at some point in the past and today this investment is valued at INR 1,200, then it would have earned 20% absolute returns.
Absolute Returns (%) =(1200–1000)/1000*100 = 200/1000*100 = 20%
You could have earned these 20% earnings over a matter of months or decades. Thus, it is extremely difficult to decide based solely on the absolute returns, if the investment is good or not. Absolute returns only tell you how much your investments grew by; they do not tell you anything about how fast they grew.
When comparing investment instruments and their earning potential thereof, both factors, how fast and by how much, are equally important. Absolute returns only account for the latter and thus we can say it is only half as efficient in determining the growth potential of the investment.
What is Compounded Annual Growth Rate (CAGR) in mutual funds?
The CAGR accounts for the tenure of the investment period and thus gives a more accurate and comparable earnings percentage. To put it in a simple formula for better understanding:
CAGR is calculated as below:
CAGR (%) = Absolute Returns / Investment tenure (years)
For instance, we have two investment options, one wherein you earn absolute returns of 10% over 20 months and the other wherein you earn 5% absolute returns over 10 months. Now, in order to decide which option is the best, you will calculate the CAGR for both and then you can decide which one is better of the two.
For option one: CAGR = 10%/1.67 (20 months/12 months equals to1.67 years) = 5.98%
For option two: 5%/0.83 (10 months/12 months equals to 0.83 years) = 6.02%
Now that both the options are compared, you can see that option two is earning better returns than the first option. In spite of the fact that option two has absolute returns that are only half of the absolute returns of the first option, the former is better earning investment and thus you must invest in it.
Evaluating your Investments
When shopping for mutual fund investments (or any other investment for that matter) you need to ensure that you consider the CAGR and not the absolute returns. This is essential because absolute returns do not consider the time-period during which the returns were earned. It is this period that is critical in determining if an investment is good or not. To put it simply, it is not just about higher returns, it is about faster and greater returns.
Even if you are looking for a Systematic Investment Plan (SIP) to invest in, there are multiple options available in the market. You need to compare these options based on the generalized CAGR wherein each installment is considered as a separate investment to derive at an overall annualized return percent. The generalized CAGR is also known as the Internal Rate of Return (IRR).
The sooner you grow your principal, the better is the compounding it earns. With SIP, it is the cost averaging effect of the units purchased that enables you to earn faster and better returns. Whereas with investments wherein the principal and interest are reinvested over the tenure, it is the rate at which these short-term interest amounts grow the reinvestment principal. The higher this interest rate is, the faster your investment will grow.
In either case, it will be the CAGR or the IRR that will help you evaluate the options more efficiently when you want to invest in mutual funds and not the absolute returns. To invest in the right funds, download the Angel Bee mobile app. With its technology-driven, ARQ, the app helps you to invest in the funds best suited to your needs without any human interference and also helps to evaluate your investments better. So start investing today!