Today, investing has changed into a process that requires not just knowledge of various financial instruments but also the ability to evaluate and understand their performance. For this task, investors can use a variety of metrics available at their disposal. One such metric that can be useful in assessing the growth potential of investments is the Compound Annual Growth Rate (CAGR). Particularly when investing in smallcases, understanding CAGR can provide valuable insights into the performance and potential of the selected portfolios, helping investors make more informed investment decisions.

Understanding Smallcases

Smallcases are portfolios of stocks or exchange-traded funds (ETFs) that are created around a specific theme, strategy, or objective. Each smallcase is carefully made by financial experts also known as smallcase managers. They develop these baskets of stocks after carefully analyzing and studying the data of different companies, ensuring that the selection aligns with the chosen theme or strategy. These investment options are suitable for both new and experienced investors, providing a convenient way to build a diversified portfolio without the need for extensive market research or stock picking. By investing in smallcases, investors can easily align their investments with specific market trends or personal financial goals.

Check out our Smallcase Guides to Understand What is Smallcase and How Does it Work?

Why CAGR Matters in Investing

In the field of investing, understanding and examining the performance of various assets and portfolios is improtant for making informed decisions. CAGR provides investors with a standardized measure of growth and provides information about the future returns and potential of the investments.

Introduction to CAGR

CAGR, or Compound Annual Growth Rate, is an important metric in smallcase investing. It represents the annual growth rate of an investment over a specified period, taking into account the effects of compounding. Unlike simple growth rates, which do not consider compounding effects, CAGR offers a more accurate measure of growth by accounting for fluctuations over time.

Importance of CAGR in Measuring Smallcase Performance

CAGR holds immense importance in measuring investment performance due to its ability to provide a consistent and easily interpretable measure of growth.

Standardized Measure

CAGR provides a standardized measure of growth that allows investors to assess the performance of smallcases consistently over time. Unlike simple growth rates or absolute returns, CAGR takes into account both the beginning and ending values of an investment, along with the effect of compounding over the investment period. This consideration ensures that investors can correctly evaluate the growth of their investments, regardless of the specific time frames or initial investment amounts. By addressing the fluctuations in the share market Cagr provides investors with the correct present value of their investment, making it a more reliable benchmark for comparing the performance of different smallcases. This standardization also enhances the reliability and objectivity of the analysis, helping investors to make informed decisions that match with their financial goals.

Long-term Perspective

Smallcase investments are done by investors who have a long term financial goal. They aim to capitalize on the continuous growth and accumulate wealth over time. In this context, CAGR is beneficial for such investors. By evaluating the annual growth rate of an investment and the stability of returns over a period of time, investors can predict the future growth rate.

Comparative Analysis

CAGR enables investors to compare the performance of different smallcases more effectively. By calculating the CAGR for each smallcase, investors can easily identify which portfolios have achieved higher growth rates in the past and make informed decisions about where to allocate their future investments. Additionally, comparative analysis using CAGR enables investors to diversify their portfolios effectively. By comparing the performance of smallcases with different themes, risk profiles, or investment strategies, investors can spread their investments across a range of assets, reducing overall portfolio risk while maximizing potential returns.

Calculating CAGR for Smallcases

Calculating the CAGR for Smallcase investments involves a straightforward formula and process :

1. Determine the beginning value of the investment or the initial investment amount.

2. Find the ending value of the investment, which could be the current value or the value after a specific period.

3. Identify the number of years over which the investment has been invested

4. Utilize the CAGR formula: CAGR = ((Ending Value / Beginning Value)^(1 / Number of Years)) - 1.

For example, consider an investor who initially invested Rs. 10,000 in a smallcase. After 5 years, the investment grew to Rs. 20,000. Applying the CAGR formula

= ( ((20000/10000)^(1/5)) - 1

= 2^(0.2) -1

= 1.1487 - 1

Thus, the CAGR or Compound Annual Growth Rate is 0.1487 or 14.87%.

Comparison With Other Performance Metrics

When evaluating investment performance, investors have the option to choose from a range of metrics other than just CAGR. Here are the differences between CAGR and other commonly used performance metrics:

Absolute Returns

Absolute returns represent the profit or loss on an investment, expressed as a percentage of the initial investment amount. For example, if the final amount is Rs.100 and the initial investment was Rs.10, the absolute return would be calculated as ((100 - 10) / 10) * 100 = 900%. Unlike CAGR, which measures the annual growth rate over a fixed number of years, absolute returns do not consider the length of the investment period. Due to this limitation, investors may not be able to accurately predict the amount of time it would take for the investment to reach a certain level of growth. Additionally, absolute returns do not account for the effects of compounding, which may result in an incomplete understanding of the investment's performance over time.Due to this investors may not be able to correctly predict the amount of years it would take for the investment to While absolute returns provide a straightforward measure of profitability, they may not accurately reflect the overall growth rate of an investment. Additionally, absolute returns may not account for fluctuations in the value of the investment over time.

Average Annual Returns

Average annual returns calculate the simple average of annual returns over a specified period. For example, if the profits were 20% and 10% in the first two years, according to average annual returns the investment has a growth rate of 15% (10+20/2). While they provide a measure of annual performance, they may not accurately show the overall growth rate of an investment. This is because average annual returns do not consider the length of the investment period, and losses in one year may be offset by high profits in another year. Further, they do provide any information about the stability of the investment over the years, making it difficult for investors to assess the consistency of returns over time.

XIRR (Extended Internal Rate of Return)

It is a financial function used to calculate the internal rate of return for investments. Unlike CAGR, which only focuses on growth rates, XIRR considers both the amount and timing of cash flows. However, while XIRR provides more detailed information about the overall return on investment, including dividends or periodic contributions, it is more complex to calculate and interpret compared to CAGR due to its consideration of cash flow timing and magnitude, requiring prior knowledge. This makes it unsuitable for a wide group of investors and analysts.

Is XIRR Better than CAGR When Evaluating Smallcase Performance?

When investments are made periodically, such as monthly contributions, CAGR falls short. This is where XIRR (Extended Internal Rate of Return) becomes invaluable.

Consider you started investing on January 1, 2018, and continued monthly contributions thereafter. Unlike a single lump sum investment, these periodic investments do not grow at a constant rate each year. XIRR accounts for this by calculating the annualized rate of return for a series of cash flows, considering both the timing and amount of each investment or withdrawal. This nuanced approach provides a more accurate picture of investment performance over time.

Role of the Time Value of Money

The time value of money is a fundamental financial concept stating that a sum of money today is worth more than the same sum in the future due to its potential earning capacity. For example, ₹100 today can be invested to become ₹105 in a year at a 5% interest rate. XIRR incorporates the time value of money, recognizing the varying growth potential of each cash flow over time. This ensures a more precise calculation of returns, reflecting the real growth or depreciation of your investments.

Why Choose XIRR Over CAGR?

CAGR's simplicity is its strength and its weakness. It calculates the growth rate over a period assuming a single initial investment and a single final value, ignoring any interim cash flows. This method works well for one-time investments but fails in scenarios with multiple investments over time.

For instance, let's say you invested ₹2 lakhs into a Dividend – Smart Beta smallcase in July 2018 and continued to invest ₹20,000 monthly via SIPs in smallcase until June 2023. Over these 61 months, your total investment would be ₹13,80,000, growing to ₹19,40,444. Calculating the absolute returns gives a 41% return, but this doesn't consider the timing of each ₹20,000 SIP.

Using CAGR here isn't possible due to the varying cash flows. Instead, XIRR, which accounts for all these investments and their timing, provides a more accurate return rate of 12.1%. This demonstrates how XIRR offers a true representation of investment performance by including the time factor and separate cash flows, unlike CAGR.

Interpreting XIRR / CAGR in Smallcases

A high XIRR or CAGR in smallcases is an indication of strong and consistent growth in the investment portfolio over the specified period. It suggests that the smallcase has been able to generate substantial returns, potentially outperforming the market or its benchmark. On the other hand, a low CAGR shows the investment has a slower growth or is underperforming compared to expectations. It could be indicative of challenges or limitations within the smallcase strategy or market conditions. In order to correctly assess the reason behind the CAGR, investors can access the factors. Several factors can influence the CAGR of smallcases:

Market Conditions

Economic factors, industry trends, and overall market performance can significantly impact the CAGR of smallcases. Better market conditions often lead to higher CAGR, while low markets may result in lower growth rates.

Portfolio Composition

The selection of stocks or assets within the smallcase portfolio plays an important role in determining its CAGR. Diversified portfolios with high-performing assets may have higher CAGR, while concentrated portfolios or poorly performing assets may have lower growth rates. This may be due to developments in particular sectors affecting the stocks of some particular companies.

External Factors

External factors such as regulatory changes, political events, new laws or technological advancements can also influence the CAGR of smallcases. Some of these may have a positive impact on some stocks, while they may have a negative impact on some others. Adapting to these external factors and identifying opportunities or risks accordingly is essential for maintaining a high CAGR.

Skills And Expertise Of Smallcase Managers

The expertise and decision-making abilities of the smallcase manager can significantly impact the CAGR. Experienced managers with a proven track record may be able to achieve higher growth rates through better portfolio management and investment decisions, while unskilled managers may take some decisions that could lead to a lower CAGR.

Conclusion

In conclusion, understanding and evaluating the Compound Annual Growth Rate (CAGR) is crucial for investors, especially when in smallcase investments. CAGR offers a standardized measure of growth, helping investors to compare different smallcases and predict future returns. It helps investors understand the performance and potential of their investments, guiding them towards informed decisions aligned with their financial goals.

Read these comprehensive Smallcase How To Guides to understand all you need to know about Smallcases:

1. Understanding What is Smallcase and How Does it Work?

2. Features & Benefits of Investing in Smallcases

3. 8 Things To Check Before Investing In A Smallcase Portfolio

4. Should You Invest In Smallcases? Are Smallcases a Good Investment?

5. Understanding the Importance of Rebalancing Your Smallcase Investments

6. How to Use Existing Demat Accounts to Invest in Smallcases

7. How To Choose Between Different Types Of Smallcases

8. Understanding Smallcase Returns, Lock-In Periods, and Minimum Investments

9. Understanding Smallcase Fees, Charges, and Taxes

10. How to start SIPs with Smallcase?

11. How Many Smallcases Should You Have in Your Portfolio?

12. Where can I view my saved smallcases?

13. How to Evaluate Smallcase Performance Using CAGR & XIRR

14. Why Use XIRR Instead of CAGR To Evaluate Your Smallcases Performance

15. How to Reinvest in a Smallcase You Had Once Exited From

16. How to Partially Exit or Sell Individual Stocks in Smallcases