When money compounds over several years, the finance world use a simple metric called compounded annual growth rate (CAGR) that helps gauge the annual compounded returns of your investment, over several years. The returns that you see in your mutual funds for periods more than one year is CAGR. If you are wondering how CAGR is different from the usual absolute returns, do see the example below.
So why do we have to look at CAGR? The main reason to use this metric is to be able to compare returns across asset classes and other economy parameters like inflation and growth. For instance, whether you put your money in deposits for 3 years or 5 years, it is common parlance to say that it gives you an interest of say 8% per annum. You never say it gives 26 (absolute return)% for 3 years. The compounded annual rate makes it easier to compare. Similarly, when you look at an inflation number of say 7% annually and your fund has a CAGR of 23%, this gives you an indication that you are generating real returns over and above inflation.
Which is greater?
Looking at the table above, a question might arise as to whether the three-year CAGR is greater than the five-year CAGR. True, over the above 5-year period, the rate of return may have been slower compared with the 3-year growth. This could be because the initial 2 of the 5 years may have been lacklustre. But it could be the reverse too. There could be periods when 3 year-returns appear lacklustre compared with 5 years as the last few years may have been volatile.
Hence, it may not be right to conclude from the above data that short-term returns are better than long term. The question is whether you will build more wealth by staying longer. And you certainly would have gained more, in the above case. Hence, instead of comparing returns across different time frames, simply use the data to compare returns for a given time frame across funds. The three-year returns of Franklin India Prima Plus for example, may be compared with say Mirae Asset India Opportunities.
Blog source: http://www.fundsindia.com/blog/mutual-funds/fundsindia-explains-compounded-annual-growth-rate-cagr/9469