Aiming & Measuring The Investment Returns using CAGR

Just because of a unit trust fund has returned an average of 10% a year over the specified period of time, it doesn't mean that your investments will also have actually grown by 10% year-over-year ... So what will be the suitable method to measure your investment against the time if you had invested some amount of money into a unit trust fund ? ... The suitable answer for this is to measure by using CAGR (Cumulative Average Growth Rate) or annualized return.

When a call have been made for investor to invest in certain funds or financial instruments ... besides than having objective of investment and understanding the risk of investment, it will be a good practice for investor to calculate the projected ROI using 'compounded annual return growth rate' or CAGR ... Frequently, investors always found that investment returns are stated in terms of an 'average return' or 'total return' ... If investors are using average return or total return to gauge his or her investment than the end result might be not accurate (normally will show higher return than actual return).

The CAGR is superior to average returns because it considers the assumption that an investment is compounded over time ... Meaning, if CAGR (or annualized returns) showing 15% for 5 years, this means that the return is around 15% every year over the period of 5 years.

For instance, let me come out with a typical situation ... Ali decided to make a lump sum investment in certain fund using his cash money of $250,000 ... since his present age is 55 years old, he decided to withdraw lump sum cash from his retirement account and to grow this money for 5 years (because the present investment return give him dividend from 6% - 7% average) ... After scouting and screening hundreds of funds, Ali has come out with realistic aim where his objective is to have about 10% return over period of 5 years.

So, once Ali identified the fund, he downloaded the fund fact sheet and start to analyse the fund performance as follow :

PERIOD FUND PERFORMANCE

2016 -0.05%

2015 20.91%

2014 9.31%

2013 26.35%

2012 14.06%

If Ali calculated the fund returns by average, then the result will be as follow :

[(-0.05) + 20.91 + 9.31 + 26.35 + 14.06 ] / 5 years = 14.12% (average return) ... This type of return is known as the arithmetic average return and is mathematically correct ... However it's only represents the average mutual fund return (of 14.1%) over period of 5 years ... This does not mean Ali's investment will get 14.1% year-by-year.

Now after Ali received an advise from his unit trust consultant ... He start to analyse deeper by using CAGR for annualized return ... (it's slightly complicated, but I'll show you the step-by-step) .... When using CAGR the formula will be :

FV = PV(1 + i)n

where : 'FV' is future value ; 'PV' is present value ; 'i' is interest rates, and 'n' is number of periods (express in the power of n)

Principal = $250,000

Year 2012 : 1 + 0.1406 = 1.1406 (because 14.06% is 14.06 / 100 and so on ... )

Year 2013 : 1 + 0.2635 = 2.2635

Year 2014 : 1 + 0.0931 = 1.0931

Year 2015 : 1 + 0.2091 = 1.2091

Year 2016 : 1 - 0.0005 = 0.9995

So, to find FV ; $250,000 x 1.1406 x 2.2635 x 1.0931 x 1.2091 x 0.9995 = $475,941.457

To calculate the CAGR, we will use FV = PV(1 + i)n ... now we want to find the 'i'

hence i = ( FV / PV )1/n - 1

where FV = $475,941.457 ; PV = $250,000 ; n = 5 years

therefore i = ($475,941.457 / $250,000)1/5 - 1 = (1.90377)0.2 - 1 = 1.1374 - 1 = 0.1374

which is 0.1374 x 100 = 13.74% .. hence the CAGR or annualized return will be around 13.7% per year for 5 years.

Let us compare the followings :-

Computation using average returns the result = 14.1%

Computation using CAGR the result = 13.7%

Ali's objective of investment is 10%

Now, let's get back to Ali's situation ... since he already know by using average return he will get 14.1% (which represents the average unit trust return over a five years period) .... and he had also calculated the CAGR and gave him annualized return of 13.7% (which means his investment will give him return of 13.7% year-by-year basis for 5 years period) ... This strategy will provide him firm decision to proceed to invest in this fund as his earlier objective is to only have 10% ROI over 5 years period, and both method of calculations gave him projected return which is exceed his expectation.

Both answers from both calculations looks relatively small (difference is only at 0.4%) ... but how about if your capital is $1 million, $10 million or bigger .... for sure the end result will also be significant ... Since the fund fact sheet usually provide data of fund's return on yearly basis, now you can use the same data's and plug-in into CAGR calculation, then investor will get the idea of how much is the annualized return from their investment.

However, if there is an information for the fund that already provided with an annualized return (refer the figure on the left), then it will not necessary to compute the return using CAGR as the value of the annualized return is already sufficient (refer to the blue outline box).

Above situation is typical and simple example ... There is more complex and complicated investment situation which is required more than a CAGR calculation ... However, measuring your investment using CAGR is good enough to have a proper aim for your investment return (rather aiming using average return or total return).

I did came across a lot of investors that still misleading with the concept of annualized return, average return & total return ... For them, they will tend to choose the fund that show them big percentage amount of return .. Usually, they will make up their mind based on the total return or average return ... When the annual statement come to them and they started to calculate their ROI ... they found out the return is smaller than their earlier expectation ... Subsequently, they start to assume that the fund is not performing, the market is crashing, the agent didn't advise them properly and so on, and finally they will redeem their investment at a wrong time (without making proper analysis) ... Of course projected ROI will always differ from actual ROI but that difference should be acceptable and not significant ...

Any investors (corporate or individual / cash or EPF) that required my advise or guidance in choosing suitable fund or want to know the annualized return of the fund ... you can reach me by email at :

E-mail : inunit.wetrust@gmail.com (Free Consultation)