Know the Key Difference: Absolute Return vs CAGR

You will frequently come across two terms- Absolute Return and Compounded Annual Growth Rate (CAGR)- while reading about portfolio performance analysis. These are two distinct metrics that evaluate your investment’s performance. Absolute Return indicates the overall increase or decrease in the value of the investment over a timeframe, whereas CAGR represents a growth rate that evens out fluctuations over time. Let us learn about Absolute Return and CAGR in this blog post.  

What is Absolute Return?  

Absolute Return indicates the total percentage increase or decrease in your investment’s value within a set timeframe, without considering the duration of holding the investment. It basically showcases the net profit or loss. For example, if you invested ₹ 1,00,000 in a Mutual Fund and its value increased to ₹ 1,50,000 in 2 years, then the absolute return would be 50%. Absolute Return works well for short-term investments, i.e. when you need a fast and simple measure of your investment’s growth or decline.  

Formula for Absolute Return is:

Absolute Return = [(Current Value / Initial Investment Value) – 1] X 100

What is CAGR?  

CAGR stands for Compounded Annual Growth Rate. CAGR represents the growth rate of an investment when profits are reinvested annually. For example, if an initial investment of ₹ 1,00,000 increases to ₹ 1,50,000 in a span of 2 years, then the CAGR would be around 22.47%. This yearly rate gives you an idea of the growth of your investment each year, by smoothening out fluctuations and variations over time.  

CAGR proves valuable when assessing long-term investments or evaluating returns from multiple investments held for varying durations.  

Formula for CAGR is:

CAGR = [{(Ending Value / Beginning Value) ^ (1/n)} – 1] X 100

where:

• The value of the investment at the end of the investment term is shown as the Ending Value

• The value of the investment at the beginning of the investment term is shown as the Beginning Value

• The investment tenure is denoted by n.

Key Differences Between Absolute Return and CAGR  

Deciding Between Absolute Return and CAGR

For Short-Term Investments

If you are looking at investments for a short-term period, e.g. under a year or a few months, then Absolute Return is the best option to consider. It offers a view of how your investment has either increased or decreased during that time frame. With short-term goals where time isn't a concern, Absolute Return gives you quick insights.

For Long-Term Investments

When you are looking to invest over a longer period of time, it's better to consider CAGR. This illustrates the annual growth of your investment and proves beneficial for planning your finances in the long run as it evens out market ups and downs and provides a view of steady growth.

When Evaluating Investment Options

When comparing investments with different time spans, CAGR is a better option as it offers a standard growth rate that simplifies the assessment of which investment has fared better annually.

For a Complete Picture

When you combine both metrics together in your investment analysis, it can provide a complete insight for assessing your investments.

Are CAGR and XIRR the Same?

No, they aren't the same, although CAGR (Compounded Annual Growth Rate) and XIRR (Extended Internal Rate of Return) are both used to evaluate investment performance across longer time periods.

CAGR is a metric that determines the growth rate of an investment by considering a single investment at the beginning of the timeframe, with profits reinvested evenly throughout the period. It offers a measure of investment growth and proves helpful in evaluating investments across comparable time spans. XIRR is a bit more complex as it takes into account various cash flows occurring at various points in time. For example, if you are investing money in tranches over time or taking out funds from the investment periodically, XIRR shows a clearer picture of your returns by incorporating these inflows and outflows and their specific timing. Simply put, CAGR is effective for one-time investments whereas XIRR is designed for more complex cash flows (i.e. multiple deposits and withdrawals) across time periods.

When it comes to Absolute Return vs XXIR, the overall growth of an investment over time is measured by Absolute Return, which ignores the timings of the cash flows and time. However, XIRR provides an accurate annualised return by taking into account irregular cash flows and their timing. 

Conclusion

Assessing investment performance requires the use of both Absolute Return and CAGR as they serve different purposes. Absolute Return is suitable to calculate growth / decline for short-term investments while CAGR offers a consistent time-adjusted growth rate for long-term investments and comparisons.  

When deciding on the metric for your investments, consider Absolute Return for quick assessments and short-duration investments and turn to CAGR for precise insights into annualised performance over time.