Important Facts For Prelims (29th April 2019)
Compounded Annual Growth Rate (CAGR)
- The CAGR is the yearly smoothened growth rate of an investment after a given interval. This is different from the average annual growth rate that investment might have seen over the two years. E.g.:
- An investment of ₹1,000 is made in 2014, which then grew 200% in the first year to ₹3,000 in 2015, but then corrected to ₹1,500 in the second year.
- In this case, the average annual growth rate would be 75%, which is the average of 200% growth in the first year and a 50% contraction in the second.
- However, a 75% annual growth rate would have yielded a return of ₹3,062.5 at the end of the second year, which is not what happened.
- To arrive at a more realistic growth rate to explain what happened, the compound annual growth rate, which basically smoothes out the average growth per year over the period under consideration.
- So, in this example, the CAGR would be 22.47%. This number shows how much ₹1,000 would have to grow every year to reach ₹1,500 by the end of the second year.
- Calculating CAGR requires three pieces of information: the start value of the investment, end value, and the number of periods under consideration.
- CAGR provides a more accurate rate of growth that can help investors arrive at a more informed decision about their investment.
- However, CAGR does not reflect investment risk. It does not provide information about how the investment has performed within that time period.