The whole purpose of savings and investments is to earn some returns. Returns are generally what we get back more than our saving or investment after the holding period. To evaluate the soundness of our saving/investment plan, it is important to be able to measure these returns in a form which can be compared with expectations, benchmarks or with other options. There are many types of returns which appear to be similar but have a different meaning. It is important to understand the difference between terms like Absolute, Annualized, Compounded, Extended Internal Rate of Return (XIRR) and Real Return so that we can correctly evaluate the performance of our savings/investments.
What figure to take as Return?
One basic thing to understand is that the returns are what you get in hand after tax. For eg if you invested ₹ 1 lakh in an FD which matured to ₹ 1.06 lakh then you gained ₹ 6,000/-. But if you are in the 30% tax bracket, then the return would be ₹ (6000-30%) = ₹ 4200/-. If you invested another ₹ 1 lakh in a stock which increased in value to ₹ 1.05 lakh then you gained ₹ 5,000/-. However, in this case the tax (if held for more than a year) would be 10%. So, the post-tax gain will be ₹ (5000-10%) = ₹ 4500/-. We can see that even if the nominal gain is higher in the case of an FD, the post-tax gain is lesser as compared to the other option. However, we express Returns in percentage to facilitate comparisons.
Absolute Return.
In the above example the post-tax returns from FD and Equity can also be expressed in percentage which would be 4.2% and 4.5% respectively. This is also known as the Absolute Returns or Simple Returns. Most of the times you will find that the financial advisors/portfolio managers include only this return in the portfolio statements. A casual investor is generally content with the feeling that the value of his investment is more than the capital invested. Calculating returns in percentage removes the complication when the invested amount is different.
For example, an investment of ₹ 25,000 growing to ₹ 28,000/- would mean a gain of ₹ 3,000/-. And another investment of ₹ 10,000 growing to ₹ 12,000/- would mean gain of ₹ 2,000/-. In absolute terms the gain in first case is ₹ 1,000/- more than the second case. But in percentage terms the gain in first case is 12% which is significantly lower than the return in the second case which is 20%. There is however a very important dimension of Time/duration missing from this calculation. It is not the gain alone, but the duration over which the gain has been accrued is also equally important.
Annualized Return.
When the duration of holding any investment is different, it becomes difficult to compare their returns. We can solve this problem by converting returns to a common holding period i.e., one year. The holding period of investments can be in terms of days, months, or years. First thing to do is to convert the holding period to the same unit i.e., day, month or year. There after multiply the absolute return by the appropriate factor ie 365/no of days held, 12/no of months held or 1/no of years held to arrive at the annualized returns.
The rates of interests specified in the case of FDs are the annual returns from the investment. However other investments like Mutual funds etc do not have any specified annual returns. To compare their performance, we need to convert returns from Mutual funds to Annualized returns. For eg a FD is giving 6.5% annual returns each year and another investment in Mutual Funds gives 25% returns over 3 yrs. Then the annualized returns of the Mutual fund investment would be 25 x (1/3) = 8.3%. Now these two returns are annualized and comparable.
Compounded Annual Growth Rate (CAGR)
For investments held for more than one year it is important to calculate the Compounded Returns. This is done by calculating the Compounded Annual Growth Rate (CAGR). The formula to calculate this is ((End Value of Investment/Beginning Value of Investment)^1/n)-1, where “n” is the number of years for which the investment is held. In the example discussed above wherein 25% gains were made over 3 yrs, we can assume that the beginning investment was ₹ 1000, and the End Value was ₹ 1250/-. The CAGR in this case would be ((1250/1000)^1/3-1)=7.7%. You can see that the CAGR for the same case is less than the annualized return. For investments held for more than one year, this is more appropriate form of measuring returns as compared to the Annualized Return.
Extended Internal Rate of Return (XIRR)
The actual scenario of investments is more complicated as there would be many cash inflows and outflows on different dates in a year. A common mode of investment is through Systematic Investment Plans (SIPs) which involves investing a particular or varying amount on different dates. Transactions in equity investments might involve both buying and selling ie cash outflow as well as inflow. Such volatile returns with multiple cash inflows and outflows can be measured using the function of XIRR in spreadsheet programs like Microsoft Excel. Most of the mutual funds indicate this return in the scheme/portfolio performance. This is by far the best way to measure returns.
Real Return.
While we are talking about only the increase in capital and the measurement of these returns, we should not forget the effect of Inflation which is bringing down the value of principle amount. So effectively there are two factors working in opposite direction on any investment. When we factor the decreased purchasing power of money over time due to inflation, we get the Real Returns. In the example of CAGR discussed above, if the annual rate of inflation was 5%, the Real rate of return would roughly be 7.7% – 5% = 2.7%. (the exact calculation would be slightly lesser at 2.57%).
At times the Real Return could be negative also. For example, the current inflation rate is around 7% and the returns on Fixed Deposits are around 5 %. In the present scenario, despite absolute gains in an FD, the purchasing power of money would have decreased by about 2% after one year.
Recommendations
- Always take the Post-tax figures to evaluate returns.
- Do not take absolute returns as the correct measure of performance. Returns from investments held for less than one year should be converted to Annualized Returns.
- Use CAGR or XIRR to evaluate or compare the performance of investments.
- Factor the Real Returns to assess the real growth in purchasing power of your money.
One reply on “Absolute, Annualized, Compounded, XIRR and Real Returns”
It’s great article. Most of us get trapped in the aura of FD. Whereas, this does not qualify as an investment. Other instruments should be compared prior committing the hard earned money.