Why CAGR is often better

Imagine a stock price that jumps by 100% in year 1 and falls by 50% in the second year. Growth
rates are 100% and -50%. Average growth rate would be 25%. Sounds like fantastic returns for
an investor. But this is wrong. Dramatically wrong. If the stocks original price had been Rs. 20.
At the end of year 1, it would have been Rs. 40, at the end of year 2 it would have been back to
Rs. 20. So, the overall growth is zero. Zilch. Nada. CAGR is 0. Remember that percentages are
calculated on the starting point. So, for the same change, going up will you will see a higher
percentage growth than coming down. If a stock goes from 100 to Rs. 1000 it is a 900% growth
rate. If it goes the other way around, it is only a 90% decline. Oops!
So, if any mutual fund manager pitches his fund to you based on average growth, ask him for the
CAGR and then politely ask him to leave.
How to compute CAGR using a calculator.
Let us do this with an example. If revenues from $300m to $ 369m in 4 years, what is the
CAGR? 300( 1+r)^4 = 369.
(1+r)^4 = 369/300 = 1.23
(1+r) = 1.23^0.25 = 1.053.
r = 5.3%
If we go from Rs. x to Rs. y in n years. x(1+r)^n = y.
(1 + r) = (y/x) ^ (1/n)
r = (y/x)^(1/n) 1.
Now, remember, this formula will give r as 0.625 or something like that. We need to think of it
as 6.25%.
Let us finish with another example.
Revenues grow from Rs. 6000 crores to Rs. 8250 crores in 5 years, what is the CAGR?
8250/6000 = 1.375
1.375^0.2 = 1.06576.
Or, r = 0.06576 or 6.58%.
nvestors may perform a small 5-step exercise to evaluate riskiness of particular mutual fund scheme, as described
below -

We will take a hypothetical example of ABC-Equity (G) scheme to compute its riskiness in our Paanch Ka Dum
(Power of 5)concept:-

1) Alpha:
Alpha basically is the difference between the returns an investor expects from a fund, given its beta, and the return it
actually produces.

Computation: Alpha = {(Fund return-Risk free return) (Funds beta) *(Benchmark return- risk free return)}.

Example-1:

Fund return (Fund performance in last one year)

75%

Risk free return

8%

Benchmark return (Sensex performance in last one year)

41%

Beta

0.69

By computing with above formula we will get alpha as 0.44 for this fund.

A positive alpha means the fund has outperformed its benchmark index. Whereas, a negative alpha indicates an
underperformance of the fund. The more positive an alpha the healthier for investors.

Here, the fund has underperformed since an alpha we computed is less than beta. It means fund has produced less
returns considering the risks fund is taking while comparing it with actual return to the one predicted by beta.

Note: The ideal time period for analyzing alpha and beta value is one year returns from their funds.

2) Beta:

Beta is a measure of the volatility of a particular fund in comparison to the market as a whole, that is, the extent to
which the fund's return is impacted by market factors. Beta is calculated using a statistical tool called regression
analysis.
By definition, the market benchmark index of Sensex and Nifty has a beta of 1.0.

It may be challenging for investors to compute it for each mutual fund scheme. However, one
need not worry. Important statistical measures for various mutual fund schemes are easily available on financial
websites like InvestmentYogi where mutual funds performance is tracked and analysed regularly.

Let us consider 3 possible scenarios in interpreting beta numbers:

[Sensex is assumed as benchmark index].

1. A beta of 1.0 indicates that the fund NAV will move in same direction as that of benchmark index. The fund
will move up and down in tandem with the movement of the markets (as indicated by the benchmark)

2. A beta of less than 1.0 indicates that the fund NAV will be less volatile than the benchmark index.
3. A beta of more than 1.0 indicates that the investment will be more volatile than the benchmark index. It is
an aggressive fund that will move up more than the benchmark, but the fall will also be steeper.
For example, if the beta of ABC-Equity (G) is 1.4 - then its considered as 40% more volatile than the benchmark
index (beta of benchmark index being 1).

Similarly, in example-1, as we have considered beta of ABC-Equity (G) fund as 0.69 - this means the mutual fund
scheme will be less volatile than its benchmark index.

Note: Conservative investors should focus on mutual funds schemes with low beta. Aggressive investors can opt to
invest in mutual fund schemes which have higher beta value for higher returns taking more risk.

3) R-Squared:
As discussed above, beta is dependent on correlation of a mutual fund scheme to its benchmark index. So, while
considering the beta of any fund, an investor also needs to consider another statistic concept called R-squared that
measures the correlation between beta and its benchmark index. The beta of a fund has to be seen in conjunction
with the R-squared for better understanding the risk of the fund.

R-squared values range between 0 and 1, where 0 represents no correlation and 1 represents full correlation. If a
fund's beta has an R-squared value that is between 0.75 and 1, the beta of that fund should be trusted. On the other
hand, an R-squared value that is less than 0.75 than it indicates the beta is not particularly useful because the fund is
being compared against an inappropriate benchmark index. This fund will not give returns similar to their
benchmark index. The lower the R-squared the less reliable is the beta, and vice versa.

The R-squared of an index fund, investing in same securities and in the same weightage as the index, will be one.

Note: Beta and R-squared are calculated based on the historical data. They give an adequate estimate of risks to be
evaluated by investors before investing.

4) Standard Deviation (SD):

The total risk (market risk, security-specific risk and portfolio risk) of a mutual fund is measured by Standard
Deviation (SD). In mutual funds, the standard deviation tells us how much the return on a fund is deviating from the
expected returns based on its historical performance. In other words can be said it evaluates the volatility of the
fund.

The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation
to its average return of a fund over a period of time.

In other words, it is a measure of the consistency of a mutual fund's returns. A higher SD number indicates that the
net asset value (NAV) of the mutual fund is more volatile and, it is riskier than a fund with a lower SD.

Note: For SD to be an effective tool, investors will need to use it in comparison with peer group mutual funds. For
example, a large-cap mutual fund is to be compared with a large-cap mutual fund with the same investment
objective(s).

5) Sharpe Ratio:
Sharpe ratio (SR) is another important measure that evaluates the return that a fund has generated relative to the risk
taken. Risk here is measured by SD. It is used for funds that have low correlation with benchmark index. This ratio
helps an investor to know whether it is a safe bet to invest in this fund by taking the quantum of risk.

The higher the Sharpe ratio (SR), the better a funds return relative to the amount of risk taken. In other words, a
mutual fund with a higher SR is better because it implies that it has generated higher returns for every unit of risk

that was taken. On the contrary, a negative Sharpe ratio indicates that a risk-free asset would perform better than the
fund being analyzed.

It tries to find out the excess return generated by a mutual fund over and above a risk-free rate of return such as an
RBI bond or a post-office savings scheme, etc.

Lets say the Sharpe ratio = 0.957 for a fund. As discussed above, the higher this ratio, the better a funds return
relative to the amount of risk taken. Here, this fund could be a risky investment option for their investors since ratio
is just near to 1 (approx.).

Quick View

Mutual Fund Evaluation Criteria

Consistent Performer -> Low SD; High SR -> Higher ranked fund
Volatile Performer -> High SD; Low SR > Lower ranked fund

Mutual Fund Evaluation Criteria:Consistent Performer -> Low SD; High SR -> Higher ranked fund
Volatile Performer -> High SD; Low SR -> Lower ranked fund

Note: Comparison should be made with peer group for accurate evaluation.

Conclusion:
This Paanch Ka Dum concept we just discussed to evaluate a mutual funds risk will enable an investor to take a
wise decision on his mutual fund investments. An investor should not blindly invest by considering only past returns
mentioned, but needs to do some research of the fund schemes and reviewing their performance at regular intervals.

Interpreting the Sharpe Ratio

The relationship between risk and return is an essential concept in finance, which argues that
riskier investments should compensate investors with higher returns and safer investments
should not experience exorbitant price fluctuations.
When comparing the performance of two securities, funds or portfolios, investors must consider
risk-adjusted returns to see if they are being adequately compensated for the risk they are
assuming. The goal is to achieve the largest return per unit of risk.
William Sharpe devised the Sharpe ratio in 1966 to measure this risk/return relationship, and it
has been one of the most-used investment ratios ever since. Here, we discuss how to calculate
and interpret the Sharpe ratio.

Components of the Ratio

Much of the ratios fame is attributable to its simplicity, as it comprises only three components.
The formula is as follows:
Sharpe Ratio = (Rx Rf) StdDev(Rx)
Where:
Rx = average rate of return from investment X
Rf = risk-free rate
StdDev(Rx) = standard deviation of Rx
When analyzing the Sharpe ratio, the higher the value, the more excess return investors can
expect to receive for the extra volatility they are exposed to by holding a riskier asset. Similarly,
a risk-free asset or a portfolio with no excess return would have a Sharpe ratio of zero.

Average Return
The Sharpe ratio was originally developed as a forecasting tool, but it can also be used to
calculate a historical risk-adjusted return. Expected average returns are used to calculate the
forward-looking ratio, whereas actual returns are used in the historical ratio.
The expected return is also known as the required rate of return because it represents the
minimum return investors require to compensate them for the added risk, which includes both
the riskiness of the investment and the time value of money.

Risk-Free Rate
The risk-free rate is the return investors require to compensate for the time value of money alone.
Typically, investors use the return on U.S. Treasury bills for the risk-free rate because it is

reasonable to assume the U.S. government will not default on its debt obligations, and thus
investors need only be compensated for the time their capital is tied up in the security.
The Sharpe ratio requires that Rf represents the average return of the risk-free rate over the time
period under evaluation. When analyzing a three-year period, investors must average the rate of
return on T-bills over the same three-year period.
Traditionally, the shortest-dated bill is used since it is the least volatile. However, some argue the
risk-free security should match the duration of the investment. Since equities theoretically have
an infinite duration, one could argue that the longest-dated bill should be used.

Standard Deviation
The standard deviation of a security measures how far returns deviate on average from its mean
(or average) return. Standard deviation is a common indicator used to measure the volatility, and
thus the riskiness, of an investment. For instance, an investment that deviates only 3% from its
mean on average is judged as less risky than an investment with a 20% average deviation.

Using the Sharpe Ratio

As an example of how to calculate and interpret the Sharpe ratio, we downloaded monthly data
on the S&P 500 index, the S&P MidCap 400 index, the S&P SmallCap 600 index and 90-day Tbills from January of 2008 to July of 2012 into an Excel spreadsheet.
Since the S&P 500 consists of 500 large-cap U.S. companies, it should theoretically be the least
volatile and also the least rewarding. Similarly, the S&P SmallCap 600 should be the most
volatile and also the most rewarding of these three indexes, as small-cap stocks are generally
considered to be riskier.
When computing the Sharpe ratio, investors must first make sure they have an abundance of
consistent and comparable data points. The more data points we use, the more likely distribution
is normal and thus the more accurate our results will be. Although we use monthly data here,
shorter intervals can be used but are more volatile and thus may require a longer time period to
compensate for the added volatility.
In Excel, we used the function =Average to calculate the average monthly return and the
function =StDevP to calculate standard deviation based on the entire population. The function
=StDevP is used when the entire population is present or when an individual is only interested
in the sample and does not want to generalize the data to represent the entire population. For
sampling, the function =StDev can be used. Basing the standard deviation on the entire
population may be preferable when comparing historical performance, whereas sampling may be
preferable when forecasting. We then apply the components to the aforementioned formula to get
the Sharpe ratio.
The resulting Sharpe ratios shown in Table 1 indicate that the S&P SmallCap 600, with a Sharpe
ratio of 0.06, provided the highest monthly return per unit of risk out of the three indexes over

the 4-year period. As expected, the S&P 500, with a Sharpe ratio of 0.003, had the lowest
volatility (standard deviation of 5.67%) and produced the lowest average return (0.05%).
Meanwhile, the S&P SmallCap 600 experienced the most volatility, with a standard deviation of
7.12%, and the largest returns, averaging 0.46%.
Table 1. Sharpe Ratio Calculations for S&P Indexes
S&P
MidCap
400

S&P
500
Average Monthly Return (%)
Monthly St. Deviation (%)
Sharpe Ratio

S&P
SmallCap
600

T-Bills

0.05
5.67
0.0031

0.40
6.78
0.0544

0.46
7.12
0.0601

0.03

-6.12
-3.48
-0.60
4.75

-6.24
-2.00
-1.14
7.61

-4.97
-3.15
0.25
3.92

0.27
0.18
0.11
0.11

Monthly Returns (%)

1/31/2008
2/29/2008
3/31/2008
4/30/2008
~

~
4/30/2012
5/31/2012
6/30/2012
7/31/2012

~
-0.75
-6.27
3.96
1.26

~
-0.52
-6.42
1.73
-0.12

~
-1.32
-6.38
4.04
-0.84

0.01
0.01
0.01
0.01

Source: standardandpoors.com
Therefore, the S&P SmallCap 600 earned an average excess return of 6% per unit of risk,
whereas the S&P 500 earned an average excess return of 0.3% per unit of risk. Although the S&P
SmallCap 600 is more volatile and thus riskier, holders of the index were much better
compensated for the risk compared to holders of the S&P 500 during that period. If investors
expect this to continue in the future, they should favor the S&P SmallCap 600 over the S&P 500,
as it would offer a higher expected return per unit of risk than the S&P 500.
Note that since all three indexes constitute diversified portfolios and that since diversification
reduces volatility, their standard deviations are quite similar. Furthermore, historical performance
is not a guarantee of future results. In general, small caps will outperform large caps when the
market is improving, but small caps will severely underperform when the market is deteriorating.
Although choosing the investment with the highest Sharpe ratio is logical, diversification and
risk aversion should be considered first.

The Ratios Weaknesses

Relative Value
The Sharpe ratio provides valuable information only when compared with another investment.
To illustrate, if Company A has a Sharpe ratio of 1.0, does that make it a good investment? What
if its competitor, Company B, has a Sharpe ratio of 3.0? All else equal, Company B is more
attractive because, although Company A appears to have a high ratio, Company Bs ratio is
better.
Moreover, negative Sharpe ratios, which are quite common during bear markets, do not provide
useful information because the risk-free asset is then outperforming the investment on a riskadjusted basis. In that case, investors often flood the bond market in search of the highest riskadjusted returns available.

Total Risk
Since standard deviation measures total risk, the Sharpe ratio does not determine what
investment is best for a diversified portfolio, rather it shows which investment is better of the
two being compared. The total risk of an investment comprises both firm-specific and systemic
risk, whereas a well-diversified portfolio should contain virtually no firm-specific risk because it
is offset by the other securities. Therefore, it may be appropriate to choose an investment with a
lower Sharpe ratio in the interest of maintaining a well-diversified portfolio.

Normal Distribution
Standard deviation requires that an investments returns are normally distributed. That is, they
must take the shape of a bell curve. The Sharpe ratio is not a suitable measurement for
investments with asymmetric expected returns.
Even if returns are normally distributed, bell curves have real limitations. For instance, they do
not take big market moves into account, which can impact long-term returns and affect leveraged
investments.
Furthermore, the time period used in the calculation will affect results. Going too far back may
not provide an accurate representation of the current situation.

Volatility
Standard deviation includes movement in every direction, which many consider a weakness
because it does not differentiate between upside and downside volatility.
However, because standard deviation and volatility measure the predictability of an investment,
which is then translated into risk, high volatility means returns are inconsistent. Strong upside
performance of a highly volatile stock can turn severely negative in an instant; thus it is still a
risky investment.

Understanding Standard Deviation

Standard Deviation is one of those statistical terms thrown around the corporate world with
vague abandon. Many business analysts dont truly understand the concept of Standard
Deviation. If youre one of those folks, you can stop living the lie. In todays Pulitzer worthy
post, youll learn how this underestimated statistical measure can help you better understand the
data youre working with.
.

What Standard Deviation Measures

Imagine you supervise two deli managers who sell bacon. Since you dont want any bacon to be
wasted, its important that these two managers hold a steady inventory. In an effort to measure
how well they manage inventory, you decide to analyze the boxes of bacon each manager
ordered in the last six weeks. Taking the average of the last 6 weeks shows that each manager
orders an average of around 32 boxes of bacon per week. On the surface, the averages make it
look like they are performing equally.

But if you look closer, youll see that one of the managers has weekly orders of 22, 34, 58, 52, 10
and 21 boxes. For this manager, the average may be mathematically correct, but it hides the
volatility of his weekly orders. In other words, sometimes the average of a dataset doesnt do a
good job representing the data. This is where Standard Deviation comes in.
.
Standard Deviation gives you a sense of how dispersed (spread out) the data in your sample is
from the Mean (Average). Said another way it lets you know if you can rely on the Mean to
give you a meaningful representation of the data.
.
In our example, we use the STDEV function in Excel to give us Standard Deviation along with
our Mean.

In the case of the first manager, the Standard Deviation is 2. This tells us that each data point in
the sample sits an average distance of 2 statistical data points from the Mean (Average). Is that
good? Well, think of it this way a Standard Deviation of 0 would say every data point is exactly
equal to Mean of the sample (32.3 in this case). So a Standard Deviation of 2 is not far off from
that, indicating that a majority of data points are positioned extremely close to the Mean. The
closer the Standard Deviation is to 0, the more reliable the Mean is. More than that though,
Standard Deviation close to 0 tells us that there is very little volatility in the sample. With a
Stanadard Deviation of 2, the first managers weekly orders are remarkably consistent.
.
In the case of the second manager, the Standard Deviation is 18.9. The average distance each
data point is from the Mean is 18.9 statistical data points. Thats a huge spread! The further away
a Standard Deviation is from 0, the less accurate the Mean for that sample. In this case, a
Standard Deviation of 18.9 alerts us that the Average shown for this manager (32.8 boxes per
week) is just not reliable. It also indicates that this managers weekly orders are extremely
volatile. Of course, with only six data points, you can confirm the volatility with your eyeball.
.
That is basic Standard Deviation in a nutshell. Although it doesnt get the attention afforded to
other statistical measures (Mean, Median, Mode, etc.), Standard Deviation is actually critical to
many statistical calculations. An understanding of how Standard Deviation works will pave the
way for you to do things like: determine the volatility of a stock, normalize comparisons between
datasets, identify outliers, create standardized z-scores, and much more.
.

How Standard Deviation is Calculated

OK, we know what Standard Deviation shows. Lets now take a look at how its actually
calculated.
Well start with this set of numbers (in black). As you can see, Ive already used the STDEV
function to calculate the Standard Deviation of 21.6 (in orange).

.
Here are the steps Excel took to calculate 21.6 as the Standard Deviation.
Note these steps are purposefully visual to better relay whats going on. In reality, all this stuff
happens instantly behind the scenes.
.
First, Excel calculates the Mean (the Average) for the Sample. In this case, the Mean is 40. It
then calculates the difference between each data point and 40. For instance, the difference
between 50 and 40 is +10 statistical data points. The difference between 10 and 40 is -30.

.
.
The next thing Excel does is Squares those differences so that all the differences will be a
positive number (+10 would become 100; -30 would become +900).

.
.
Excel then adds up all the Squared Differences to get the Total Squared Differences.

Next, Excel uses the Total Squared Difference to calculate the Sample Variance. This is done by
dividing the Total Squared Differences by the count of data points in the sample minus 1. In this
example the count of data points is 7, so we divide the Total Squared Differences by 7-1.

.
.
Finally, Excel calculates the square root of the Sample Variance. This square root becomes our
Standard Deviation.

.
.

Population Standard Deviation vs Sample Standard Deviation

In statistics, youll often hear the terms Population and Sample. These terms refer to the
completeness of the data in your possession. The differences between the two are sometimes not
all that clear.
.
If youre using a complete dataset, youre using a population. An example of a population
would be if you were analyzing the time in service for all the sales reps in your company. You
would have the data for all the sales reps that exist in your company; a complete population.
.
If you are using a partial set of data, or a subset of data, youre dealing with what is called a
sample. An example would be if you were analyzing sales data for one quarter of a year. A
quarter is merely a subset of an entire years data, so in this case, youre working with a sample.
.
The reason this population and sample designation matters is because the calculation for
Standard Deviation changes slightly depending on the nature of the data youre dealing with.
Specifically, the way you calculate the Sample Variance changes. Remember in Step 4 of the
calculation steps above? We said that Excel divides the Total Squared Differences by the count of
data points in the sample minus 1. Well, this only applies if your data is a sample (a subset of a
bigger data pool).

If your data is made up of the entire population, the calculation in Step 4 changes to divide the
Total Squared Differences by the complete count of data points. In other words, there is no need
to subtract 1.

.
This difference in calculation will obviously yield different Standard Deviations.

.
So why the difference in calculation? Well, the difference is not an Excel quirk. Its an actual
statistics tenent called Bessels Correction. Bessels Correction states that when you use a sample
dataset instead of a population, you need to subtract 1 from the count of data points used (written
in the statistics world as N-1). This correction accounts for the bias introduced by estimating a
Mean using a subset of data instead of using the true population Mean. The reasoning behind the
need for this correction is admittedly a bit difficult for us non-math geeks to wrap our brains
around. Ill try to explain it in my simplified understanding.
.
When you use a sample, youre using a subset of data chosen from the true population. In this
case, you wont have the benefit of using the true population Mean. You will need to estimate a
new Mean based on data you grabbed in the sample. This estimated Mean is already biased
towards fitting the data chosen in the sample, so you need to exclude that one point (the
estimated Mean) from calculating the Sample Variance. This is called losing a degree of
freedom. Another way to look at it is this. If I said you could have five variables in an Excel
formula, but one of them would have to be used to calculate the Mean, you would have only four
variables available to you (5-1). The fact that you have to calculate Mean loses you a degree of
freedom.

.
If you use a population set instead of a sample set, you have the benefit of the true population
Mean. So youre not losing a degree of freedom by being forced to introduce an estimated Mean.
Thus there is no need to subtract 1.
.
.

Standard Deviation Formulas in Excel

Excel has the ability to handle Standard Deviation calculations for both population and sample
datasets. Simply click in any cell and start to enter a =STDEV. Youll see a tool-tip dropdown
that gives you, what seems to be, a ridulous number of Standard Deviation functions.

Heres a quick rundown of what each function does.

STDEV: Calculates Standard Deviation for a sample using Bessels Correction (N-1).

STDEVP: Calculates Standard Deviation for a population.

STDEV.S: Calculates Standard Deviation for a sample using Bessels Correction (N-1).
This function technically replaces the STDEV function.

STDEV.P: Calculates Standard Deviation for a population. This function technically

replaces the STDEVP function.

STDEVA: Calculates Standard Deviation for a sample using Bessels Correction (N-1).
Allows for text and TRUE/FALSE values.

STDEVPA: Calculates Standard Deviation for a population. Allows for text and
TRUE/FALSE values.

.
I cant imagine any scenario where I would use the STDEVPA and STDEVA functions. I think
you can safely ignore those.
.
As far as I can tell, there is no discernible difference between STDEV.S and STDEV. Microsoft
says you should move toward the newer STDEV.S function, but you can technically use those
two functions interchangably.
.
Likewise, I dont see any discernible difference between STDEV.P and STDEVP. Although
STDEV.P is the newer function, you can use those two functions interchangably.
.

.
Until next weekHappy Mathing!