For an investor, it is highly important to know what kind of returns various financial instruments will generate in order to choose the perfect investment option. There are various ways through which investors can measure investment returns. But first, we’ll see why we need to quantify investment returns.
Why is Quantification of Investment Returns Necessary?
It is often wondered, that why do we need to quantify returns when we can just look at the definite returns and take the decision. However, definite returns are not generalised for each value of investment. We need to have a particular “percentage” that denotes returns from that specific instrument, for all amounts of investment that the investors make. That “percentage” is what we call quantification of investment returns. Let’s understand this with the help of an example.
Let’s say an investor invests Rs. 5,000 and Rs. 20,000 in two different instruments which have grown to Rs. 5,500 and Rs. 21,500 in a span of one year. If we look at the definite returns, they are Rs. 500 and Rs. 1,500 respectively. It would look like the second instrument delivers higher returns, so one should opt for that. However, this is misleading, as the two investment amounts are different. Therefore, we need to calculate the returns in terms of percentage. The annual rate of return for the aforementioned instruments stands at 10% and 7.5% respectively.
The above “percentages” are the same of each value of investment in that specific instrument. It makes it easier for the investor to decide which instrument to invest in, considering the risk exposure is the same for both.
Different Ways to Measure Investment Returns
Now that we’ve understood why quantification of investment returns is important, we’ll look at the different ways we can do so. For mutual fund investment, measuring investment returns via these methods present a clear picture about whether you should invest in a particular scheme or not.
Here is a list of different methods used to measure investment returns and which method works best for which purpose:
- Absolute Returns
Returns on investment are calculated on various time duration and relations. Absolute returns simply refers to the total amount which you gain on your principal investment.
For instance, if you have invested ₹1 lakh in fixed deposits and after 5 years, the total amount you get is ₹ 1.5 lakh, then absolute returns are 50% of the principal investment.
- Annualised Returns
The concept of absolute returns is rarely used for computing investment returns because the lack of time horizon gives a blurry picture of actual capital appreciation. One should look at the annualised returns to get a better idea of investment returns which also includes the time value of money.
For instance, if an investment grows from ₹1 lakh to ₹2.5 lakh in 5 years, absolute returns are 150%, but annualised returns would be 20.11%.
- CAGR (Compound Annual Growth Rate)
CAGR is one of the best metrics used to calculate annualised returns. It is essentially a rate of return when applied on a yearly basis would make an investment grow from the initial value to the final value.
It involves the calculation of compound interest applicable over a particular time horizon.
For example, if an investor wants to know what should be the interest rate for growing an investment from ₹1 lakh to ₹2 lakh, s/he will find out the Compound Annual Growth Rate for the investment. CAGR for this investment comes out to be 14.87%.
- Price Returns
Price Return simply refers to the difference between the final value and initial value of investment. For a specific investment portfolio, it takes into account just the capital appreciation on your investment and not any dividend returns or interest income.
For example, for any mutual fund investment, if the Net Asset Value (NAV) at which you buy units of the fund is ₹10 and after a year the NAV of the fund is ₹11, the price returns value stands at 10%.
- Total Returns
Total Returns method to measure investment returns assumes that the dividends earned are reinvested upon declaration. Apart from the price returns, it also takes into consideration the income generated through dividend distribution as well as interest income.
For mutual funds with growth options, where dividends are reinvested, total returns instead of price returns should be used for measuring returns.
Measuring returns on investment (ROI) every now and then should be an important part of one’s financial planning. Having in-depth knowledge about the aforementioned methods will help you in making better financial decisions and decide when to divert your investment to other saving vehicles