Why CAGR Matters More Than YoY Returns
Understand why Compound Annual Growth Rate (CAGR) is the superior metric for evaluating investments compared to year-on-year returns that can mislead investors.
Your friend boasts: "My fund gave 45% last year!" Meanwhile, you're feeling down about your "boring" 12% return.
But here's what your friend isn't telling you—their fund lost 35% the year before. When you do the math, your steady 12% actually beat their rollercoaster.
This is why CAGR matters more than yearly returns.
The Problem with YoY Returns
Year-on-Year (YoY) returns show a single year's performance. They're easy to understand but dangerously misleading.
The Misleading Math
| Year | Fund A (Volatile) | Fund B (Steady) |
|---|---|---|
| Year 1 | +50% | +12% |
| Year 2 | -30% | +12% |
| Year 3 | +40% | +12% |
| Year 4 | -20% | +12% |
| Year 5 | +35% | +12% |
Simple average:
- Fund A: (50 - 30 + 40 - 20 + 35) / 5 = 15% average
- Fund B: 12% average
Fund A looks better with 15% vs 12%, right? Let's see the actual money.
₹1 lakh invested:
| End of Year | Fund A Value | Fund B Value |
|---|---|---|
| Year 1 | ₹1,50,000 | ₹1,12,000 |
| Year 2 | ₹1,05,000 | ₹1,25,440 |
| Year 3 | ₹1,47,000 | ₹1,40,493 |
| Year 4 | ₹1,17,600 | ₹1,57,352 |
| Year 5 | ₹1,58,760 | ₹1,76,234 |
Fund B's steady 12% actually beats Fund A's volatile 15%!
Calculate the real return: Use our CAGR Calculator to find true performance.
What is CAGR?
CAGR (Compound Annual Growth Rate) is the constant rate that would take your investment from starting value to ending value over the given period.
Formula:
CAGR = ((Ending Value / Beginning Value)^(1/Years) - 1) × 100
For the example above:
- Fund A: ((₹1,58,760 / ₹1,00,000)^(1/5) - 1) × 100 = 9.7% CAGR
- Fund B: ((₹1,76,234 / ₹1,00,000)^(1/5) - 1) × 100 = 12.0% CAGR
Fund B's CAGR is higher despite looking "boring" in YoY returns.
Why YoY Returns Mislead
1. Volatility Destroys Returns
This is called "volatility drag" or "variance drain."
| Year 1 | Year 2 | Simple Avg | Actual CAGR |
|---|---|---|---|
| +20% | +20% | 20% | 20.0% |
| +30% | +10% | 20% | 19.6% |
| +40% | 0% | 20% | 18.3% |
| +50% | -10% | 20% | 16.2% |
| +60% | -20% | 20% | 13.1% |
Same 20% simple average, but more volatility = lower actual returns!
2. Loss Requires Bigger Gain to Recover
| Loss | Gain Needed to Recover |
|---|---|
| -10% | +11.1% |
| -20% | +25.0% |
| -30% | +42.9% |
| -40% | +66.7% |
| -50% | +100.0% |
A 50% loss needs 100% gain to break even. This is why volatile funds often underperform over long periods.
3. Recency Bias Distorts Perception
| Fund's YoY Returns | Impression | Reality |
|---|---|---|
| +5%, +8%, +10%, +45% | "Fund is improving!" | May have gotten lucky |
| +30%, +20%, +15%, +10% | "Fund is declining!" | May be normalizing |
Recent returns dominate our perception, but CAGR cuts through recency bias.
CAGR vs Other Metrics
CAGR vs Absolute Return
| Metric | What It Shows | Limitation |
|---|---|---|
| Absolute Return | Total gain/loss | Ignores time |
| CAGR | Annualized gain/loss | Shows real rate |
Example: 100% return sounds great—but is it over 5 years (14.9% CAGR) or 10 years (7.2% CAGR)?
CAGR vs Rolling Returns
| Metric | What It Shows | Limitation |
|---|---|---|
| CAGR | Single point-to-point rate | Depends on start/end dates |
| Rolling Returns | CAGR over many periods | More data, shows consistency |
Rolling returns (e.g., all 3-year CAGRs over 10 years) show how consistent a fund has been.
CAGR vs XIRR
| Metric | Best For | Limitation |
|---|---|---|
| CAGR | Lump sum investments | Can't handle multiple cash flows |
| XIRR | SIP investments | Requires cash flow data |
For SIP, use XIRR. For lump sum, use CAGR.
How to Use CAGR Correctly
1. Compare Same Time Periods
Wrong: "Fund A's 5-year CAGR is 15%, Fund B's 3-year CAGR is 18%, so Fund B is better."
Right: Compare both over 5 years, or both over 3 years.
2. Use Longer Periods
| Period | Reliability |
|---|---|
| 1 year | Low (high variance) |
| 3 years | Medium |
| 5 years | Good |
| 10 years | Excellent |
One-year CAGR is essentially a YoY return—not meaningful.
3. Consider Starting Point
CAGR from market peaks will look worse. CAGR from market bottoms will look better.
Solution: Use rolling returns or compare across multiple start dates.
4. Adjust for Risk
Two funds with 12% CAGR are not equal if one had 30% volatility and other had 15%.
| Fund | CAGR | Volatility | Risk-Adjusted |
|---|---|---|---|
| A | 12% | 30% | Poor |
| B | 12% | 15% | Good |
Look at Sharpe Ratio for risk-adjusted comparison.
Real-World Examples
Misleading Mutual Fund Ads
Ad claim: "Fund XYZ gave 42% returns!"
What they're hiding:
- 42% is trailing 1-year return
- Previous year was -15%
- 5-year CAGR is only 9%
What to look for:
- 3-year, 5-year, 10-year CAGR
- Comparison vs benchmark CAGR
- Rolling returns consistency
Stock Market Headlines
Headline: "Market up 20% this year!"
Reality check:
- Previous year: -15%
- CAGR over 2 years: Only 1.7%
Always ask: "20% from what base?"
Insurance ULIP Sales Pitch
Agent: "You'll get 15% returns!"
Reality:
- Gross returns: Maybe 12-14%
- Charges: 2-3% annually
- Net CAGR: 9-11%
- Comparable mutual fund: 12% CAGR
CAGR after all charges is what matters.
CAGR Benchmarks
Asset Class Historical CAGRs (India, 20-year)
| Asset | Approximate CAGR |
|---|---|
| Savings account | 3-4% |
| Fixed deposit | 6-7% |
| Gold | 8-10% |
| PPF | 7-8% |
| Nifty 50 | 11-13% |
| Mid-cap funds | 13-16% |
| Small-cap funds | 14-18% |
| Real estate (varies) | 8-12% |
Use these as reference points when evaluating any investment.
Mutual Fund Category CAGRs (10-year)
| Category | Average CAGR | Top Performers |
|---|---|---|
| Large Cap | 11-12% | 13-14% |
| Flexi Cap | 12-14% | 15-17% |
| Mid Cap | 14-16% | 18-20% |
| Small Cap | 15-18% | 20-25% |
| ELSS | 12-14% | 15-17% |
If a fund claims 20% CAGR in large-cap, be skeptical—verify the time period.
Common CAGR Mistakes
1. Annualizing Short Periods
Wrong: "Fund gained 5% in 3 months = 20% annualized!"
Right: Short-term returns can't be reliably extrapolated. Report as absolute return.
2. Cherry-Picking Period
Fund houses often highlight their best-performing period. A 3-year CAGR starting March 2020 (COVID bottom) will look exceptional.
3. Ignoring Dividends
Some CAGR calculations use price-only returns, ignoring dividends. Always use total return CAGR.
4. Not Accounting for Taxes
Pre-tax CAGR of 15% ≠ post-tax CAGR of 15%
| Investment | Pre-Tax CAGR | Tax Impact | Post-Tax CAGR |
|---|---|---|---|
| Equity MF | 15% | 12.5% LTCG | ~13% |
| Debt MF | 8% | At slab rate | 5-6% |
| FD | 7% | At slab rate | 4-5% |
Conclusion
YoY returns are noise. CAGR is signal.
| When You See | Think |
|---|---|
| "Fund gave 40% last year!" | What's the 5-year CAGR? |
| "Average return of 15%" | What's the actual CAGR? |
| "Doubled in 5 years" | That's 14.9% CAGR—good, not great |
| "10x in 20 years" | That's 12.2% CAGR—solid equity return |
Train yourself to immediately convert any return claim to CAGR. It cuts through marketing hype and reveals true performance.
Calculate real returns: Use our CAGR Calculator to find the true annualized growth rate of any investment.