KNOWLEDGE CENTRE Mutual Funds Investment Guide / Difference between Absolute Returns and CAGR
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# 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.