The right way to calculate returns!
and why you're doing it wrong
Okay, imagine that you invest Rs. 10,000 today and exactly a year from now you get Rs. 12,000. If I ask you what your return percentage is, you’ll straightaway say 20%.
Easy, right?
Okay, now if I tell you that after 3 years you get Rs. 15,000 and ask you the return percentage, you’ll say 50%.
Which is (partially) right. The return on your investment is 50%, which is known as the absolute return.
However, this is not the best way to calculate returns, because it doesn’t consider the duration of investment. This 50% here is over 3 years. But since money gets compounded, your annual return here will actually be 14.47%. This means that every year, your money is assumed to be growing by 14.47%. So Rs. 10,000 is assumed to be becoming Rs. 11,447 after one year, Rs. 13,103 after the second year and eventually Rs. 15,000 after year 3. This is known as the Compounded Annual Growth Rate, or CAGR, which is the annualized return.
And this is also something you can compute easily using the compound interest formula that we had learnt in school [A = P(1+r/100)^n], where r is the CAGR. I hope you remember 😁
Now, let’s have some fun.
If I were to tell you that you invested Rs. 10,000 today and you got Rs. 5,000 each year for 3 years, what is your return?
Sure, your absolute return is 50%, but what about your annualized return?
How will you calculate the CAGR now using the compound interest formula? What time period will you take?
Confused? Don’t worry. Hum kis din kaam ayenge? 😉
So here’s where I’ll introduce concept # 3, known as Internal Rate of Return (or IRR).
[Before that, the last date for filing your Income Tax return is 31st July. If you need help with return filing, click here, and we’ll connect you to our partner CA who will help you file your returns]
Now coming back to IRR. Essentially, if you were to calculate returns for the above scenario (10K invested, with 5K received every year for 3 years), you’ll do it, not by absolute returns or CAGR. You’ll do it by calculating the IRR. How and why? Let’s understand.
Basically, first you’ll need to understand the concept of “Time Value of Money” with a simple transaction. You give Rs. 5,000 each to two friends Raj and Aman at 0% interest. Raj returns the full 5,000 to you at the end of 1 year, but Aman gives you Rs. 2,500 in two tranches 6-6 months apart. In this case, which situation is better for you?
Obviously, Aman’s transaction is better, because you get Rs. 2,500 in 6 months itself.
That is the most fundamental rule of finance - Money received today is worth more than money received tomorrow.
And that’s primarily due to two reasons:
Inflation means that the value of your money will be lower 6 months later, than what it is today
When you receive Rs. 2,500 from Aman, you can invest it for the remaining 6 months and earn interest on that money too
Therefore, money received earlier is more valuable than money received later.
Now, here are two scenarios:
You invest Rs. 10,000 and you receive Rs. 15,000 after 3 years
You invest Rs. 10,000 and you receive Rs. 5,000 every year for 3 years
Here, calculating CAGR for transaction (2) is not possible using the Compound Interest formula. But if you calculate IRR for both, you’ll get an IRR of 14.47% for Transaction (1) and…wait for it…23.38% for Transaction (2)!!
So you see, calculating IRR paints a very different picture for your investments, because it considers the time horizon for your cash outflows and cash inflows.
Now, here’s the last part - if for the above transaction, you invested Rs. 10,000 - and got back Rs. 5,000 in year 1, Rs. 3000 in year 2 and Rs. 7,000 in 2.5 years, you will need to calculate something known as XIRR (Extended Internal Rate of Return). Why, you ask? Because IRR is calculated when repayment periods and amounts are uniform. In case either of them is not uniform, you calculate the XIRR.
Phew! That’s all you need to know about returns. But how do you calculate IRR and XIRR? Simple - Use Ms Excel. Just enter the cash flows as below and calculate it using the XIRR function. Why I’m saying only XIRR is because XIRR is applicable for equal or unequal cash flows/periods, so you may use just XIRR function in excel.
Well, that’s about it! Hope this gives you some perspective on which kind of returns to calculate for different kinds of investments. Quick question - if you do Mutual Fund SIPs, which type of returns will be most accurate? Let me know in the comments here! 😁
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Till next week, Adios! 😁
CAGR return?