Introduction
Investment returns are the profits or losses that investors make on their investments over a period. It is crucial to understand how different measures of investment returns can provide different values. In this blog post, we will explore various methods of calculating investment returns and shed light on their implications. By gaining a deeper understanding of these concepts, you can make informed investment decisions. Let's dive in!
Example Scenario
To illustrate the calculation of investment returns, let's consider an example. Imagine you invested ₹10,000 in a stock or mutual fund scheme at the beginning of the year. After two years, the value of your investment has grown to ₹12,000. We will now calculate the returns using different methods.
Absolute Return
Absolute return represents the total return on your investment, regardless of the duration it was held.
Calculation:
Absolute Return = (Final Value - Initial Investment) / Initial Investment
Absolute Return = (₹12,000 - ₹10,000) / ₹10,000 = 0.2 or 20%
In this example, the absolute return on your investment is ₹2,000, indicating a 20% increase in the value of your investment. This measure represents the overall gain or loss experienced during the entire investment period.
Simple Annual Return
Simple annual return provides the average return on your investment over a two-year period.
Calculation:
Simple Annual Return = (Final Value - Initial Investment) / (Initial Investment * Number of Years)
Simple Annual Return = (₹12,000 - ₹10,000) / (₹10,000 * 2) = 0.1 or 10%
Therefore, the simple annual return for this investment over a two-year period is 10%.
Compounded Annual Growth Rate (CAGR)
CAGR represents the average annual return on your investment, considering compounding effects.
Calculation:
CAGR = (Final Value / Initial Investment) ^ (1 / Number of Years) - 1
CAGR = (₹12,000 / ₹10,000) ^ (1 / 2) - 1 = 0.095 or 9.5%
The CAGR of your investment is 9.5%. It provides a better understanding of the investment's performance on an annual basis, taking into account both the time factor and the compounding effect of reinvested earnings.
IRR: Internal Rate of Return
IRR is a measure of the profitability of an investment, considering the timing of cash flows.
Example:
IRR calculates the discount rate that makes the present value of all future cash flows from an investment equal to the initial investment. In this example, the IRR is 11.571%.
XIRR: Extended Internal Rate of Return
XIRR is a modified version of IRR that considers investments with irregular cash flows and includes the date of each cash flow.
Example:
XIRR provides a more accurate measure for investments with irregular cash flows. In this example, the XIRR is 10.222%.
To understand how to calculate returns for SIP using the XIRR method click here to read
RRR: Risk-Adjusted Return
RRR is a measure that assesses the return of an investment relative to the level of risk involved.
Example:
Suppose we have two investment options, Option A and Option B, with different expected returns and levels of risk.
Option A: Expected Return: 12% , Standard Deviation: 8%
Option B: Expected Return: 10%, Standard Deviation: 4%
To calculate the Risk-Adjusted Return (RRR) using the Sharpe Ratio:
Sharpe Ratio = (Expected Return - Risk-Free Rate) / Standard Deviation
Assuming the Risk-Free Rate is 4%,
Sharpe Ratio of Option A = (12% - 4%) / 8% = 1
Sharpe Ratio of Option B = (10% - 4%) / 4% = 1.5
Option B has a higher Sharpe Ratio (1.5) compared to Option A (1), indicating a better risk-adjusted return.
Sharpe Ratio is a widely used tool in mutual fund analysis for comparing funds and understanding their relative return performance, considering the level of risk involved.
Misleading Marketing Practices
It is important to be aware of misleading marketing practices employed by the investment industry. Marketing materials may present annual returns instead of CAGR, making investments appear more profitable than they actually are. Unrealistic return projections can also lead to poor investment decisions.
Example 1
An insurance company may advertise a 10% annual return on investments, while the actual return is closer to 5%. It's essential to evaluate the actual Internal Rate of Return (IRR) to determine the true return on investment.
Example 2
In the case of a premium payment of ₹3 lakhs for 12 years, where you receive an annual 8% return from the 20th year for another 12 years, the principle being returned at the end, it may seem attractive due to the higher return compared to a bank deposit of 7%. However, the real return on the premium payment is only 5% when considering the compounding effect during the cooling-off period.
Evaluating Performance
When evaluating investment performance, it is crucial to compare returns using consistent measures such as XIRR or CAGR. This ensures an apples-to-apple comparison, allowing for better decision making.
The Role of Time in Returns
Understanding the time value of money is vital in comprehending investment returns. Over time, investments usually grow due to the compounding effect, leading to increased returns. This concept is often referred to as the "seventh wonder" by scientists, as explained by Einstein. Click here to read more about Time Value of Money
Regulatory Framework and Investor Protection
Regulators, such as SEBI, mandate the disclosure of absolute returns for investments with durations of less than one year. This ensures investors are aware of the actual returns rather than misleading CAGR figures. Unrealistic annualized returns can be misleading, as markets do not consistently yield high returns every month.
Conclusion
In this blog post, we have explored different methods of calculating investment returns and discussed the implications of misleading marketing practices. It is crucial to conduct thorough research and understand the various types of return numbers to make informed investment decisions. By evaluating performance accurately and considering the role of time in returns, investors can protect their interests and avoid falling prey to misleading information. If you have any further questions or require assistance with evaluating your portfolio returns, feel free to reach out to me through the contact form. Thank you for reading!
Further Reading
For more details about fixed vs. variable returns in mutual funds:
- [Fixed vs. Variable Returns in Mutual Funds]
To understand how to calculate returns for SIP using the XIRR method:
- [Performance of Investments]
- [Excel in Personal Finance: Part 4]
- [Calculating SIP Return using Microsoft Excel]
To gain a better understanding of returns and numbers, it's important to grasp the concept of the time value of money:
Contact us
To discuss your portfolio returns or seek assistance with your investments, please reach out to me through the [Contact Us] form on my blog.
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