The illusion of CAGR - part I

By definition, Compounded Annualized Growth Rate (CAGR) is per annual return compounded annually and used for calculating the return over a one year period. 

For example, if the return in any particular scheme of a mutual fund or stock for the last 5 years is 12% CAGR, which means if Rs. 1000 had been invested 5 years back, now its value became Rs. 1762. However, the misconception among the investors is that the growth of 1000 to 1762 has happened in linear fashion i.e. every year the return was generated @12% p.a. whereas actually, CAGR does not indicate the growth of funds in a straight line manner like FD.

In reality, per annum growth could be much higher, lower, or around 12% in any of the periods in between during the investment phase. This also means the growth rate could be positive as well negative in some of the years and even than 5 years CAGR could be 12%. Here investor fails to understand this fluctuation (volatility) in market-linked instruments and believe that equity investment has high potential to deliver but ignore the risk of getting a negative return or subdue return during interim years. 

Most investors don't mentally prepared to get such high volatility/fluctuation in investment returns on day to day basis and therefore failed to stick with a particular scheme if they don't see positive returns for a prolonged period of time and prefer to get out of the scheme even if getting loss.

You can see from the below mentioned seven examples, rate of return is the same which is 12% CAGR for 5 years, but the fluctuation on year on year basis is drastically different and the risk associated with a negative return is always ignored by the investor. Although in the long-run equity market always return back to its mean average despite volatile fluctuations.

Year	Principal	Rate	Interest	Total
1	1000	12%	120	1120
2	1120	12%	134	1254
3	1254	12%	151	1405
4	1405	12%	169	1574
5	1574	12%	189	1762

Year	Principal	Rate	Interest	Total
1	1000	-40%	-400	600
2	600	27%	164	764
3	764	32%	245	1009
4	1009	42%	424	1433
5	1433	23%	330	1762

Year	Principal	Rate	Interest	Total
1	1000	4%	40	1040
2	1040	-25%	-260	780
3	780	48%	374	1154
4	1154	29%	335	1489
5	1489	18%	273	1762

Year	Principal	Rate	Interest	Total
1	1000	18%	180	1180
2	1180	27%	319	1499
3	1499	-20%	-300	1199
4	1199	30%	360	1559
5	1559	13%	203	1762

Year	Principal	Rate	Interest	Total
1	1000	19%	188	1188
2	1188	0%	0	1188
3	1188	-10%	-119	1069
4	1069	-30%	-321	748
5	748	136%	1014	1762

Year	Principal	Rate	Interest	Total
1	1000	10%	100	1100
2	1100	15%	165	1265
3	1265	25%	316	1581
4	1581	35%	553	2135
5	2135	-17%	-373	1762

Year	Principal	Rate	Interest	Total
1	1000	8%	80	1080
2	1080	10%	108	1188
3	1188	12%	143	1331
4	1331	14%	186	1517
5	1517	16%	245	1762

In all the above cases, we get the same result - an investment of Rs. 1000 and getting the maturity of Rs. 1762 after 5 years at 12% CAGR. What makes the difference in the process of achieving that result. that investors need to understand before making the decision just only on a return parameter!