While most of us talk and strive towards generating alpha, i.e. above average return over the market return, however, time horizon plays a far more important role in wealth creation. It’s better to invest in a business or stock with little lower compounding rate, however with far higher longevity or sustainability of growth.
Case I: INR 100 at a compounded annual growth rate (CAGR) of 12% p.a. for 15 years would yield INR 547 at the 15th year.
Case II: INR 100 at a CAGR of 10% p.a. for just 18 years would translate to INR 556, i.e. even at 20% p.a. lesser return than the original return, it would trump the original value in nominal terms in just additional 3 years. Now, If, you increase the time horizon by another 7 years, i.e. 25 years, the value at the end of 25 years translates to INR 1,083; i.e. 2x of the original value.
So, next time, if someone brags about his returns, a better question for you to ask him would be “Since how many years?”
Another follow-on question which also needs to be asked is “Since when?”.It is important to understand the base year which is taken into consideration while calculating CAGR growth; lower value in the base year will show inflated growth rates, often colouring the mind with optimism, thereby giving the illusion of generating higher returns in future – or at least continuing the historical trend in future as well!!
Are you sure? As size of the corpus increases, the returns usually tend to become lower.
Base Year is often used by Investment Managers to showcase their performance since 2008/09 (March 2020 will also get added now!!) – either in terms of actual performance or benchmark via their model portfolio
- Actual Performance being extremely unlikely because it is extremely difficult to deploy money when the world was perceived to be coming to an end. March, 2020 of this year was something remarkably similar!!
Also, this also suggests that the fund was sitting on idle cash!! Really? How much?
- Fund’s model portfolio – this is like a big “IF” with the assumption that human beings are rational beings and would not get affected by the oscillations of greed and fear – Are you kidding?
No doubt, Einstein had said “Compounding is the 8th wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Disclaimer: Please note that these are my personal views. While I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014, all investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action.
Absolutely true. Many financial institutions dupe people with misleading benchmark figures.