If you are considering investing to reach your financial goals, Systematic Investment Plans (SIPs) are an excellent way to do so. While opting for this investment method, you will often come across the term Compound Annual Growth Rate (CAGR). If you wonder what CAGR is and why it matters in your investment journey, this article will give you the necessary lowdown, including how to use it while investing in SIPs.
Before we discuss CAGR, let’s first understand what an SIP is.
What are SIP and CAGR
SIP is a method that lets investors invest a fixed amount in mutual funds at regular intervals, which could be weekly, monthly or quarterly. It promotes disciplined and consistent investing and is particularly popular for long-term financial planning.
To evaluate how your investments are performing, CAGR is a financial metric that calculates the average annual growth rate of a lump-sum investment over a given period. It assumes that profits are reinvested, reflecting the compounding effect of growth. For instance, CAGR is helpful when analyzing company performance, such as if you are tracking Tata Motors share price or its profit growth over time.
Why CAGR Matters in SIP Investments
Evaluating the performance of SIPs can feel tricky due to market fluctuations and volatility. This is where CAGR becomes a crucial tool. It’s widely used in finance to evaluate the performance of lump-sum investment investments or to project future growth.
While SIP returns may fluctuate due to market conditions, CAGR offers a standard way to measure their performance by showing an annualized growth rate. If you are looking for long-term investments, it is important to know how your investment performed over time on an average every year. When calculating CAGR, it’s assumed that the profits will be reinvested at each year’s end within the time horizon. This means the investment earns returns on its returns, also known as compounding
Some of the significant uses of CAGR are:
Compare and measure past performances and future returns projection
CAGR is used to compare and measure investments’ past performance or to project their expected future returns. It is also useful to compare the growth rates of various data values, such as company revenue growth or economic value, over time.
Compare multiple alternatives
Investors can compare the CAGR of two or more alternatives to assess how well one stock performed against other stocks in a market.
How is CAGR calculated?
A CAGR calculator is available as an online tool or on popular financial websites. Spreadsheet software also offers in-built CAGR calculation functions. They simplify the calculation by allowing you to input values and instantly receive the result.
The CAGR formula needs just three things: the investment’s starting value, ending value, and the number of years. To calculate, divide the ending value by the starting value, raise it to the inverse number of years, and then subtract it by one.
Below is the CAGR Formula:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1.
In short, The CAGR formula depends on three variables, namely, the beginning value, the ending value, and the number of years (N).
Calculating CAGR with an Example
Imagine you invested ₹10,000 in a mutual fund 3 years ago, and today the investment has grown to ₹15,000.
Here’s how to calculate the CAGR:
Identify the values:
- Starting Value = ₹10,000
- Ending Value = ₹15,000
- Number of Years = 3
Apply the CAGR formula:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1.
Plugging in the values:
CAGR = (15,000 / 10,000) ^ 1/3 −1
- Simplify the calculation:
CAGR = (1.5) ^ 1/3−1 - Using a Calculator: (1.5) ^ ⅓ = 1.1447
- Subtract by 1: CAGR=1.1447−1=0.1447
- Convert to percentage:
CAGR = 0.1447×100=14.47%
Final Answer:
The CAGR for your investment is 14.47% per year.
This means that, on average, your investment grew by 14.47% annually over the 3-year period.
Conclusion
In conclusion, CAGR is a valuable metric for evaluating investment performance, especially when it comes to SIPs. By understanding CAGR, you can make informed decisions about your investments and track their progress over time. Remember, CAGR takes into account the compounding effect of growth, providing a clear picture of your investment’s average annual return. Whether a seasoned investor or a beginner, CAGR is an essential tool to help you achieve your long-term financial goals. However, it’s best to consult with a financial advisor to make informed decision while investing.
