What are the different measures of return on investment?

Comparing various investments is normally done on the basis of how well they performed in the end, which is typically expressed as an interest rate or a percentage gain. You should begin to grasp how various measurements of return are computed and how they’re used to assist you analyze your investment/portfolio by reading product literature, brochures, websites, calculators, and more.

In general, calculating the rate of return and comparing the outflows (costs incurred) and inflows (income) from an asset are how returns on investment are determined. The inflows may come from capital gains or losses resulting from a shift in the investment’s value, as well as periodic payouts like interest from fixed income securities, dividends from equity assets, and capital gains. Investors in mutual funds benefit from capital gains and dividends as returns. Almost all funds and investments have performance metrics that are measured using standard return measures, even though the types of returns may vary. 

Types of Return Measures

Let’s look at some of these types of return measures.

Absolute return

The growth or decline in your investment is known as an absolute return. They are given as a value percentage. It is frequently confusing that we do not account for time when computing absolute returns. This technique of computing returns is typically applied to time periods shorter than a year. The investment was first made with Rs. 1,000,000, and its current market value is Rs. 1,40,000. The absolute return in this scenario would be 40%. Absolute returns are frequently used to calculate real estate returns. For example, how many “x” times has the value of your property increased? Since time is not taken into account, absolute returns over a one-year period can frequently be quite misleading; the more time the period, the more misleading the results become.

Annualized Return

The annualized returns on your investment indicate the annual growth in value. One “return” is computed by averaging or spreading the investment’s overall return over a number of years. The inclusion of the compounding impact is one crucial feature of annualized returns. Even if a number doesn’t seem particularly appealing at first, it may have a significant effect on your return over time. This compounding effect is something that investors should consider when examining annualized returns.

Using an example, let’s examine which is superior. 15% five-year annualized returns or 85% absolute returns? People typically believe that 15% times five is 75%, hence 85% is quite significant. But with compounding’s power, 15% yields a far larger effective return of 101.14%. This disparity in returns will increase to startling proportions over time.

Total Return

The total return is the real rate of return on investment after accounting for all types of inflows and appreciation. For equities and mutual funds, capital gains and dividends would be factored into the overall return calculation. When an investment yields numerous streams of income or returns, it is crucial to take the overall returns into account in order to determine the investment’s true value.

Let’s take an example where you invest at Rs. 20 and the price/NAV increases to Rs. 22 after a year. You also received a dividend of Rs. 2 per share or unit at some point during the year. When you add everything up, you will have a profit or return of Rs. 4 and a total return of 20%. 

Return from Point to Point

The point-to-point returns, as their name implies, quantify annualized returns between two points in time. In order to compute the point-to-point returns of a mutual fund scheme, it is imperative to possess a start and end date. Returns are frequently expressed in terms of predetermined timeframes, such as one year, five years, ten years, and so forth. In this case, the “From Date” refers to the time period prior to the “To Date,” which is always the present or the date of the report or computation. Investors should be aware that the selection of “To Date” can significantly impact returns and may or may not accurately reflect the performance or quality of the investment.

Annual Growth Rate Compound (CAGR)

CAGR is a typical mutual fund return that is used to assess a fund’s performance over extended holding periods. CAGR is used for longer periods to produce compounded annual returns, while annualized returns are typically used to convert returns of less than a year to an annual return. When normalizing all of the investment’s highs and lows throughout the course of the time, CAGR takes into account the investment’s start and end values as well as the duration of the investment. It’s crucial to remember that CAGR does not account for numerous cash flows or periodic investments. Therefore, CAGR might not give a clear image if there are several investments made during the year at different times. It functions best when we are thinking about one-time investments on a point-to-point basis.

Internal Rate of Return Extended (XIRR)

Which metric should we use in the event that CAGR is inappropriate and we have various cashflows, such as inflows and outflows as in the case of SIP? The solution is XIRR.

When calculating the returns from a sequence of cash flows, the Internal Rate of Return (IRR) is a frequently used metric. When calculating returns on assets with numerous cash flows that occur at various times, the extended version of IRR, or XIRR, is utilized. Each cash flow’s CAGR is computed in XIRR and then added together to provide the total CAGR.

Mutual Fund Regulations

In India, there are certain regulations governing what is to be reported regarding plan returns when discussing mutual funds. Significantly, unless it’s an assured returns program, regulations prohibit anyone from making any return promises. According to regulations, the scheme’s benchmark must be used to compare and display the scheme’s performance. When the scheme age is +3 years, point-to-point returns and CAGR as of a certain date must both be revealed. The returns must be computed using the values of the “Total Returns” Index. Documents pertaining to the scheme demonstrate this.

In summary

Once you are aware of these metrics, there are a few considerations to make while assessing investments. First and foremost, you must compare like products; that is, the product categories you are comparing ought to be the same (the time frame and measurement also matter). Another thing to keep in mind is that previous returns might or might not occur again. Although returns play a significant role in decisions, they are not the primary one. It is also necessary to take into account a person’s risk tolerance and investing goals, as well as their readiness to take on risks, liquidity, and short-term versus long-term investment demands. Your success as an investor will depend on your comprehension of all these variables, not just returns.