It is important not only to invest but also to have a clear understanding of the return on investment. As the stock market soared to all-time highs, there were reports of stocks gaining between 4,000 and 7,000 per cent. Is it really an annual return? Or Absolute Return Income? If there is no understanding of the returns, the investment will be withdrawn quickly with a 1000% gain in the portfolio. What is actually received will be a nominal return.
This article is based on a question raised by Vishnu on the returns on mutual funds.
His question was why returns from mutual funds have been declining in the long run. It is estimated that many of the best funds do return 50 % to 60 % in the first year. In that case, he suspects, he will not be able to withdraw 60 % of his returns and invest in other funds. Vishnu also had a reasonable suspicion that those who check their returns by depositing only in the bank could get a return of 60 % every year if they withdraw their investment and reinvest in another fund every year.
There are three main terms used to calculate the return on investment. These are Absolute Return, CAGR and XIRR.
1. Absolute Return
Absolute return is the total income from the investment plan. The investment period is irrelevant here. For example, suppose you invest Rs 1,00,000. Three years later, the investment was Rs 1,50,000. Accordingly, the gain is Rs 50,000. That is, 50 %.
2. Annual Income (CAGR)
The return on long-term investment should be calculated on the basis of annual returns. That is, the annual income (CAGR) is calculated on the basis of the compound interest gain on the income received each year. The return on a lump sum investment, including a mutual fund, is calculated on the basis of annual return. Just because you see a 12 percent or 15 percent return in two or five or ten years, does not mean that you have returned that much every year.
The compound annual interest rate (CAGR) is calculated as the annual interest rate for five to ten years. If the annual growth rate is 15 per cent, the return on investment may not be as high as 15 per cent every year. It may also have received a negative return in a few years. CAGR stands for Annual Growth Rate over a period of time. CAGR stands for Flexible Income over a period of time.
CAGR can be calculated if the holdings in the equity fund are held for more than one year. Returns can be calculated even if the holding period is in years, months or days.
For example, suppose you invest Rs 1,00,000. Three years later, the investment was Rs 1,50,000. Accordingly, the gain is Rs 50,000.Accordingly, the yield was 14.47 per cent for a period of three years and 8.45 per cent for a period of five years. Note that this difference is in the absolute return of 50%. That is, the absolute return of 50 per cent is 14.47 per cent at the three-year CAGR and 8.45 per cent at the five-year CAGR. Therefore, CAGR is the best way to calculate the return on investment over a given period of time. This return calculation is ideal for a lump sum investment. At the same time, the XIIR formula would be more appropriate for SIP investment.
CAGR formula
Divide the current value by the amount invested and find its 1 / N (N- denotes how many years) exponent. CAGR is the percentage obtained by subtracting the sum from the amount received and multiplying it by 100 (The CAGR formula is given for further explanation. Use online CAGR calculators for easy calculations).
X.I.R.R.
XIIRR stands for Extended Internal Rate of Return. This formula is suitable for investing in Systematic Investment Plan (SIP) and Systematic Withdrawal Plan (SWP) in mutual funds.
Let me illustrate with an example. Suppose you invest Rs 10,000 each for 13 months. 14,500 was received on maturity. Only Rs 13,000 was invested. The gain is Rs 1,500. CAGR is not applicable here as it is an investment for different periods. XIIRR is ideal because it is a step-by-step investment. That is, the initial Rs 10,000 was given 12 months to grow. But for the 13th month, there was no time to invest Rs 10,000. The return on this formula is calculated by averaging the period over which the total investment was received. Accordingly, the return was 19.8 per cent. That is to say, XIIIR is an acronym that is suitable for assessing returns based on fixed term investment and withdrawal from it.
Frequently asked Questions (FAQs)
Are you loaded with questions in your head pertaining to CAGR? If so, then this FAQ section will address all your queries.
Who Uses CAGR?
It is used by both the investors as well as the companies to evaluate how various investments have grown and performed over time. CAGR is an easy metric to compare with other investments so that companies can understand which investment can offer them higher returns.
Is CAGR similar to the Average Annual Growth Rate?
No. CAGR and Average Annual Growth Rate are not the same metrics. CAGR is a statistic instrument based on the growth that measures the compound annual return of investments over a specific period. Whereas, AAGR (Average Annual Growth Rate) is a simple growth metric that does not take into account compounding. It calculates the arithmetic average of an investment. AAGR may prove better in predicting trends, but CAGR is unbeatable in analyzing the growth of your investment.
When should one use CAGR and AAGR?
If your comparison needs to be in the longer-term, let us say from 5-10 years, then Compound Annual Growth Rate is the best tool. It is because it can describe the long-term or historical performance of an investment.
If you need to estimate your future returns from a particular investment, then AAGR is the best tool. It is because it offers results based on past performances. Moreover, it is unbiased in its estimation of future returns.