Explaining CAGR and Absolute returns

When it comes to investing, most investors will try to assess the returns first. Sometimes the 6-month return is 50%, while a 3-year return is only 20%, leading to curiosity about knowing the difference between these two returns. In this article, we will try to understand the differences between absolute returns and CAGR in detail and find out how they are helpful practically in assessing the performance of an investment.


Absolute/Simple Return:

Absolute/simple return is a basic method of calculating return on any investment. It just indicates the percentage change in the prices of an asset from the beginning point to the ending point. The Simple/Absolute Return calculation requires only two components, the beginning value and the ending value.

The formula for calculating the absolute return is ((Ending value (EV) minus Beginning value (BV)) divided by (Beginning Value (BV) *100 = ((EV-BV)/BV) *100

But there is a problem in estimating the fund performance based on this form of return

Let us consider two mutual funds, and we need to decide which fund has performed well in the past.

Fund A: NAV of ₹60 has become ₹90 in 2 years

the result is ((90-60)/60) *100 = (30/60) *100 = (0.5) *100 =50%

Fund B. an investment of ₹80 becomes ₹120 in 3 years.

the result is ((120-80)/80) *100 = (40/80) *100 = (0.5) *100 =50%

As shown above, when we use the formula of absolute return, the result is the same 50% in both cases.

But, by seeing the return and period of investments in the above two cases, we can clearly say that Fund A has outperformed Fund B by generating the same return in 2 years. Absolute return reflects point to point return; this is because it does not take the time/period of the investment into consideration. This return will show us only the absolute value of the return percentage generated by an investment.

Thus, we can use the absolute return to compare point-to-point returns, i.e., to assess returns generated by an investment during the same period. It misses the average return given by a fund over all the years in the past and considers performance only for a particular period.

Though with many limitations, absolute returns can work well for understanding investment performance for short periods, i.e., less than a year. Traders mainly use this type of return to assess the performance of their positional or intraday trades.


CAGR (Compounded Annual Growth rate):

Now let us check a form of return, which considers the growth and decline of investment and considers the time as well, by calculating the average growth rate of the compounding called CAGR.

The formula to calculate CAGR is {((BV/EV) ^(1/T)) -1} *100

Where BV = Beginning Value of Price

EV = Ending Value of Price

T = Time Period

Considering the same illustration of Funds, A and B as in the absolute returns, now the return generated varies.

Fund A: NAV of ₹60 has become ₹90 in 2 years

the result is {((90/60) ^ (1/2))-1} *100 = 22.47%

Fund B. an investment of ₹80 becomes ₹120 in 3 years.

the result is {((120/80) ^ (1/5))-1} *100 = 14.46%

Here, the CAGR of Fund A is 22.47%, and the CAGR of Fund B is 14.46%, unlike a similar value of 50% in the absolute return for both the cases because of the consideration of time/period in calculating the returns.



Thus, absolute return is more appropriate for short-term positions and comparing investments returns for a particular period. Using CAGR is more suitable for assessing the performance or comparing returns of different investments over a long period.

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