Difference Between CAGR vs Absolute Returns

There are multiple methods for calculating a return on investment—absolute returns and CAGR are two such popular methods. 

Below, we explain both absolute returns and CAGR and how they differ from each other.

What is Absolute Returns?

An absolute return refers to the total return generated on an investment, expressed in percentage terms. So, an absolute return shows how your initial investment value has grown with time. 

An absolute return is primarily concerned with only two terms: initial investment value and the final investment value/ maturity amount. This means an absolute return lays no emphasis on the tenure of investment. 

For instance, if an AMC states that its fund has returned an absolute return of 10%, you have no way of knowing whether it was earned over a few months or a few years.

Thus, absolute returns are more suitable when your holding period for investment lasts under a year. Some of the popular absolute returns-based investment strategies include futures & options, arbitrage, and leverage.  

How is Absolute Return Calculated?

Calculating absolute return is pretty simple. The absolute return formula is as follows:

Absolute Returns (%) = [(Current Value / Initial Investment Value) – 1] * 100

For instance, if you initially invest Rs. 1,00,000, which grows to Rs. 1,79,000, then

Absolute Returns = [(1,79,000 / 1,00,000) – 1] * 100

Absolute Returns = 79%

In this case, the investment has returned 79%, but we are unclear about how long it took to generate such high returns. Nor does this metric provide any insight into the future growth potential of this investment.

To elaborate, if you were given the option to either invest in Fund A, which earns 12% or Fund B, which returns 8%, would fund A necessarily be a good choice under all circumstances? That will depend on how long it took to generate such returns—something that a CAGR calculation can help clarify.

What is CAGR?

CAGR, or Compound Annual Growth Rate, measures the rate of return of an investment over a certain period, in percentage terms. In other words, CAGR is the imaginary growth rate at which an investment is expected to grow steadily on an annually compounded basis.

CAGR is also known as an annualised return. It smoothens the variations in the return of an investment over the years. It is a useful tool for comparing investments with different returns earned over multiple time periods.

A long-term CAGR enables investors to assess the future potential of an investment, as it eliminates the impact of any market shocks occurring in the short term.

How is CAGR Calculated?

The CAGR calculation is slightly more complicated than the absolute returns’ computation. The formula for CAGR is stated below.

CAGR = [{(Current Value / Initial Value) ^ (1/Number of Years)}-1] * 100

To illustrate, let’s expand on the previous example of a hypothetical initial investment of Rs. 1,00,000. Its performance over the next 5 years has been tabulated below.

In this example, the Rs. 1,00,000 investment has grown to Rs. 1,79,000 over 5 years.

CAGR = [{(1,79,000 / 1,00,000) ^ (1/5)} – 1] * 100

CAGR = 12.35%

Hence, this states that an investment worth Rs. 1,00,000, after growing at a steady rate of 12.35% every year for 5 years, will finally be worth Rs. 1,79,000. 

You can easily calculate the CAGR for your investment through Angel One’s CAGR calculator, as long as you know the initial value, maturity value, and tenure of the investment.

Additionally, in the above table, all the YOY returns are the absolute returns for that specific year. 

CAGR vs Absolute Returns

The main difference between CAGR and absolute returns lies in consideration of the time period. As stated above, one cannot fathom how long it took to earn the absolute return of 79% in the previous example. Whereas, a CAGR return is calculated for a specific time period. Hence, the investment’s 5-year CAGR in the above example is around 12.35%. This rate would change as the time period changes to some other figure, such as 3 years or 10 years.

CAGR vs Absolute Return: Which is the Better Option?

Both absolute returns and compounded annual growth rate (CAGR) provide valuable investment performance evaluations. Only, addition to time-frame differs.

In the ideal world, CAGR might be the best measure for investments of longer duration. The basis of this is that it calculates the yearly increment of an investment over time which may vary during the period of investment to give a complete picture concerning growth pattern.

However, when computing absolute returns, one only considers the variance between initial investment value and final value at time of sale. This ignores time factor for ascertaining profit or loss.

For investments held less than a year, simplicity may make absolute returns more appropriate. Nevertheless, in cases where investments span several years, CAGR gives insight into their pattern of volume increase.

Key Points to Consider Before Investing Based on CAGR

• CAGR is not an annual rate of return on investment. It is a hypothetical number, which smoothes out the returns on an investment, over a specific period.
• CAGR does not account for market volatility. For example, in the example stated above, the returns on this investment are highly volatile. They are negative after the first year, peak in year 3, and are minuscule in year 4. But CAGR provides us with a steady growth rate of over 12%.
• CAGR provides no valuable information when investment is made through SIPs. This is because, unlike a lump sum investment, a SIP involves multiple inflows and outflows, thus necessitating that each monthly instalment is treated as a new investment. In such cases, investors should, instead, focus on the internal rate of return (IRR). You can calculate it by using the XIRR formula in an excel sheet.

Conclusion

To summarise, investors should compare different investments on their CAGR returns before choosing to invest long-term. This metric can further be improved by calculating risk-adjusted returns to account for volatility levels. Also, investors should rely on IRR in case they are investing through SIPs.

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