Absolute Return vs CAGR: What’s the Difference?

When looking at mutual fund performance, investors come across two key numbers: Absolute return and Compound Annual Growth Rate (CAGR). Both measure how the fund has done but in different ways. Understanding the difference between these two is key to evaluating your funds and setting expectations for the future.

This article will explore the differences between absolute return and CAGR in detail. 

What are Absolute Returns?

Absolute returns are a simple way to understand the profit or loss made on an investment. It shows how much your initial investment has grown and is the easiest way to calculate returns. It’s expressed in percentage terms.

For example, if you invested ₹10,000 in a fund and now its value is ₹15,000, then the absolute returns on your investment will be 50%. It doesn’t take into account the time duration of the growth and that’s its biggest drawback.

To compute absolute returns, you need two things – final investment amount and the initial investment amount. These returns don’t compare to a benchmark. So absolute returns are more suitable if you have an investment period of less than a year.

What is CAGR?

Absolute returns are point-to-point returns on investment while CAGR is year-on-year growth. In simple terms, CAGR is like figuring out the steady pace at which your investment has grown each year, assuming it grows at the same rate every year.

It calculates the average annual return of an investment based on the initial amount invested, the final value and the time period over which the investment was held. So CAGR is also called annualised return. CAGR like absolute returns is also expressed as a percentage.

It smooths out the fluctuations in the fund’s performance and presents it in a way that’s easy to understand. It also makes the growth rate comparable, no matter what asset you’re looking at.

How Is Absolute Return Calculated?

It is quite simple to compute absolute returns. Its formula is as follows:

Absolute Return = {(Final Value - Initial Value)/Initial Value} * 100

For instance, if you invested ₹1,00,000 in a mutual fund which grew to ₹1,75,000, then the absolute returns on it will be calculated as follows:

Absolute Return = (1,75,000 - 1,00,000)/1,00,000 * 100

Absolute Return = 75%

While the return of 75% seems good, it remains unclear as to how long it took to generate it. This return could have been made over months, years or even a decade. This way you have no idea whether the returns are good or bad. 

You can only know the total return from an investment and not how fast it rose or depreciated. Hence, it is not possible to compare the returns of two investments.

How Is CAGR Return Calculated?

To calculate CAGR, the following formula is used:

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

To extend the above example, let’s assume the investment grew from ₹1,00,000 to ₹1,75,000 in five years. Therefore, the CAGR on the investment would be:

CAGR = [{(1,75,000/1,00,000) ^ (⅕)} - 1] * 100

CAGR = 11.84%

Hence, this shows the investment has grown at an annual rate of 11.84% to reach ₹1,75,000 in five years. 

It shows the average growth of the investment. The investment could likely have seen a fall in some years and grown exponentially in the next. The below table shows a hypothetical scenario about how the investments could have done year-on-year but the annualised growth rate would be 11.84%.

Therefore, CAGR smoothens the impact of stock market fluctuations and gives an overview of the overall growth in investments. 

Calculating CAGR can be a cumbersome process. But you can quickly calculate the CAGR for your investment using INDmoney’s CAGR Calculator. Just input the initial value, final value, and the investment period.

CAGR vs Absolute Returns

After looking at the meaning and understanding how absolute return and CAGR are calculated, let’s look at the differences between the two.

CAGR vs Absolute Return for Mutual Funds - Which is Better?

Both CAGR and absolute return give you insights into your mutual fund investments, but the only difference is time.

Absolute return is good for a simple view of total performance. You can use it to understand the total increase or decrease in investment value. You can use absolute return for investments with a tenure of less than a year. But if your holding period is more than a year, it makes sense to use annualised returns or CAGR. It can also be used to compare investments over different time periods. The ultimate choice depends on whether you want a normalised growth rate or a simple total performance measure.

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