Understanding Returns on Investments

– By Meghashyam Sinkar

“Kitna return milega or Kitna return dega” ..These are the questions we often ask while making an investments . However , there are different ways of return calculation to arrive the return on investment (ROI) based on the nature of investment like one time or regular or irregular intervals .

Let us understand different ways of calculation of returns. 

Absolute Return 

This is nothing but calculating appreciation over your initial investment in percentage terms . 

E.g You invested Rs 100,000/- in August 2013  and you have received Rs 200,000/- in August 2018 .  The absolute return in this case will be 100% 

Absolute Return = 100 * ( Amount Received – Amount Invested )/Amount Invested

= 100* ( 200000-100000) / 100000

= 100 %

It is also called point to point return . This method does not take time into consideration and hence may not give the right picture on your return on investment .

Compound Annual Growth Rate (CAGR) 

CAGR is the year-over-year growth rate of an investment over a specified period of time . This method takes time into consideration and most commonly used method of finding return on investment .This method is applicable only when there is single cash flow and the holding period is more than one year .

In the above example ,the CAGR will be 14.87% .

CAGR  =  [ ( Amount Received / Amount Invested ) ^ ( 1/ number of years ) ] -1

= [( 200000/100000)^(1/5)] -1

= 14.87%

Though CAGR is better than absolute , but has certain limitations . It does not reflect volatility because it shows steady growth rate year on year . But the returns from mutual funds, direct equity , real estate , gold  will not have steady growth rate year over year in reality.

Internal Rate of Return (IRR )

IRR is used when there are Multiple cash flow e.g Systematic Investment Plans ( SIP ) , Systematic Transfer Plan (STP) . It is used to calculate the returns given for the amount invested at a fixed interval /period . There should be equal distance between two instalments e.g. after every 1 month or 3 month or one year . 
  

Amount Invested 1 01/01/12 -5000
Amount invested 2  01/01/13 -8000
Amount Invested 3 01/01/14 -6000
Amount Invested 4 01/01/15 -10000
Amount Invested 5 01/01/16 -6500
Amount Received  01/01/17 53000
IRR 14.40%

Note : Since amount invested is an outflow from your account , put “ – ” negative sign before each invested amount and Amount received should have “+” positive sign before it .

Extended Internal Rate Of Return (XIRR)

When the amount is invested at irregular interval / period , then we can’t use IRR and thats when XIRR is used .

In above example of IRR the interval is annual , If the same amount is invested at irregular period as below 

Amount Invested 1 01/04/12 -5000
Amount invested 2  01/10/13 -8000
Amount Invested 3 05/03/14 -6000
Amount Invested 4 01/02/15 -10000
Amount Invested 5 01/08/16 -6500
Amount Received  01/01/17 53000
XIRR 16.45%

XIRR is used in case of receipt of dividends either mutual fund or stocks. It can also be used to compare two business ideas.

Awareness about calculating returns with right method for investment is one of the essential factor, to conclude good or bad investment.

Happy Investing !!!