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The return on an investment may be calculated using both absolute returns and the compound annual growth rate. The whole return on an investment, independent of time, is measured using absolute returns. Over a certain period of time, the compound annual growth rate indicates the return on investment. These measures are used to determine the return on investment. But the methods used by each to determine the return are different. This post highlights the difference between CAGR vs absolute return and discusses both terms in detail.
What are absolute returns?
You must be wondering what is absolute return in mutual fund. An absolute return represents the total percentage gain or loss realized on an investment. It indicates how the initial investment value changes over time. It focuses on the initial investment value and the final investment value without considering the duration of the investment.
Here is an example. Suppose an asset management company announces a ten percent absolute return on its fund. It does not provide information on whether this return was achieved over a short period. It could be a few months or a longer period spanning several years.
Therefore, absolute returns are particularly relevant for investment holding periods shorter than a year. Strategies such as futures and options, arbitrage and leverage often rely on absolute return measurements. This helps to assess performance and make investment decisions.
How is absolute return calculated?
Absolute return computation is a rather easy process. The following is the absolute return formula:
Absolute Returns (%) = [(Current Value / Initial Investment Value) – 1] * 100
For instance, if you initially invest ₹ 1,00,000, which grows to ₹ 1,79,000, then
Absolute Returns = [(1,79,000 / 1,00,000) – 1] * 100
Absolute Returns = 79%
Although the investment has returned 79% in this instance, we are unsure how long it took to achieve these substantial returns. Furthermore, this indicator offers no information about this investment’s potential for future development.
To put it another way, would Fund A always be a wise investment if you had the choice between Fund B, which yields 8% returns, and Fund A, which earns 12%? That will depend on how long it takes to get those kinds of returns, which may be better understood with the use of a CAGR estimate.
Use annual returns for long-term financial goals
Employing annualized returns is vital for achieving long-term financial objectives. You may be strategizing for goals such as retirement, funding education and accumulating wealth over extended periods. It’s essential to grasp the average annual growth rate of investments thoroughly. Through the assessment of annualized returns investors can effectively gauge the performance of their portfolio over time. They can do so while taking into account the compounding effects.
What is CAGR?
The CAGR full form is Compound Annual Growth Rate. It expresses the rate of return on investment as a percentage over a certain time period. It is the estimated growth rate at which an investment is anticipated to develop consistently over time.
An annualized return is another name for CAGR. It evens out the fluctuations in an investment’s return over time. It is a helpful tool for comparing assets that yield varying returns over extended periods of time.
It removes the effect of any short-term market impacts, a long term CAGR helps investors evaluate an investment’s future potential.
How to calculate CAGR?
Now you know what is CAGR. To get the compound annual growth rate, divide the investment’s ending value by its beginning value, take the nth root of that result (where n is the number of years), and deduct 1 from the outcome.
The following is the CAGR formula to get the compound annual growth rate:
CAGR = (Ending balance/beginning balance) ^ 1/n – 1
Ending balance = Value of the investment at the end of the investment period
Beginning balance = Value of the investment at the beginning of the investment period
N = Number of years you have invested
Let’s illustrate this concept using an example of the Compound Annual Growth Rate (CAGR). Imagine Elon invested ₹ 2000 in an equity mutual fund in 2020. The fund’s net asset value (NAV) remained unchanged in 2020, but in 2021, it rose to ₹ 2100. By the time of maturity in 2022, the NAV had increased to ₹ 2500.
In this scenario, the CAGR growth is calculated to be 7.72%. Alternatively, we can interpret this as the NAV of the mutual fund Elon invested in experiencing a Compound Annual Growth Rate of 7.72%.
Uses of CAGR
CAGR has many uses. Permitting equitable evaluation based on average yearly growth rather than absolute figures standardizes the appraisal of investment success. The compound annual growth rate facilitates long-term investment planning by projecting future values and assisting investors in making educated selections. CAGR evaluates investment risk. A yearly compound growth rate continuously positive throughout time indicates steady, dependable growth that appeals to risk-averse investors.
Difference between CAGR and absolute returns
Find the difference between absolute return vs annual return below:
| Aspect | Compound Annual Growth Rate (CAGR) | Absolute Returns |
| Definition | A measure of an investment’s mean annual growth rate over a specified period, assuming the investment had compounded at that rate annually. | The total percentage change in the value of an investment over a specified period, without considering the time taken. |
| Time Sensitivity | Reflects the smoothed annualized growth rate over the investment period. | It does not consider time; it represents the overall growth or decline. |
| Interpretation | Provides a standardized measure to compare investments with different timeframes. | Represents the actual gain or loss over the entire investment period. |
| Usefulness | Useful for assessing the performance of an investment over a long period, especially for comparing investments with different timeframes. | It provides a clear indication of an investment’s overall gain or loss without considering the time it took to achieve it. |
| Limitations | Doesn’t consider volatility within the investment period. | Doesn’t provide insights into the consistency or volatility of returns. |
In summary
Both absolute returns and Compound Annual Growth Rate (CAGR) are valuable metrics for evaluating investment performance. However, the distinction between the two lies in their treatment of time. In the case of investments held over longer durations, CAGR provides a more comprehensive measure. CAGR delineates an investment’s annual growth rate, which varies throughout the investment horizon. Conversely, absolute returns solely consider an investment’s initial purchase value and final sale value to compute returns.
For investments spanning less than a year, absolute return calculation is appropriate. However, CAGR offers a clearer perspective for investments held for periods exceeding one year. Additionally, CAGR facilitates comparisons between investments held for varying durations. It’s worth noting that when dealing with periods shorter than one year, CAGR may overstate or understate returns, thus potentially distorting the actual return.
FAQs
To transform absolute returns into CAGR, the process involves calculating the nth root of the ratio between the current value of the investment and the initial investment, then subtracting 1 from the result. Put differently, the formula ((Current value of the investment / Initial investment)^(1/n)) – 1 yields the CAGR value.
The CAGR function in Excel computes the Compound Annual Growth Rate of investments, indicating returns over a defined timeframe. This feature is frequently utilized by financial analysts, business proprietors, and investment managers within spreadsheet applications.
Absolute return accounts for an investment’s selling price and initial purchase price. The disparity between these two prices is divided by the purchase price, and the resulting value, when multiplied by 100, provides the absolute return percentage. This metric is particularly beneficial for investment periods shorter than one year.
An Absolute Return fund represents a category of investment vehicle aiming to achieve consistent and positive returns across various market conditions. This is accomplished through diverse investment strategies, including derivatives, arbitrage, short selling, leverage, and other techniques.
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