How to calculate your investment return?

Let us look at some finer points when it comes to calculating return on investment.

Dec 11, 2019 12:12 IST India Infoline News Service

You must have heard ad nauseam that investing in any asset class is a risk-return trade-off. Normally, the concept of risk is considered to be a lot more complex compared to returns. That is understandable considering that risk has a systematic and unsystematic component to it. However, even returns can be nuanced and the term returns, per se, can be quite misleading. Let us look at some finer points when it comes to calculating return on investment.

Arithmetic return vs. CAGR returns
This is the first nuance you need to understand about return on investment. Let us take an illustration. You buy a mutual fund at a NAV of Rs100. At the end of 3 years, the NAV of the fund appreciates to Rs139. That is 39% returns over 3 years or 13% annualized. Unfortunately, it is not that simple. In this calculation, you ignore the compounding effect. Your Rs100 would have grown to Rs113 at the end of 3 years. Now the second year return would be calculated on Rs113 and not on Rs100. Hence, the compounded returns will be lower. In this case the compounded annual growth rate (CAGR) will be 11.6% and not 13%. You can check it like this, (100 x 1.116 x 1.116 x 1.116) = Rs.139. When it comes to return on investment, CAGR is more scientific than simple arithmetic returns.

Nominal returns vs. real returns
This is another nuance pertaining to calculation of returns. Normally, if you use any automated return calculator on the website, it gives you an option to adjust for inflation. Nominal returns are what you earn on your investment and when you deduct the rate of inflation you get the real return. For example, if your nominal return on an investment is 12% and the inflation rate is 4% then your real return will be 8%. Real returns are a useful barometer in an economy where inflation is at a higher rate since inflation results in loss of purchasing power and drains returns to that extent.

Absolute returns vs. total returns (TRI) for mutual funds
This was an announcement made by SEBI in 2018 that all mutual funds should disclose their performance vis-à-vis the index based on TRI rather than on absolute returns. Why is this distinction important? Absolute returns are calculated as the difference between the two NAVs over a two year period. However, this can be misleading when you compare with the index. That is because, the index does not earn dividends, whereas the fund earns dividends paid out by companies. This can distort the picture of fund outperformance. For example, if the absolute returns on the fund are 14% and the index is up by 13%, then the outperformance is 1%. Under TRI, the average dividend yield on the index of 1.4% will be added and the Nifty TRI will be 14.4%. Effectively, if you use TRI the fund would have underperformed the index. This puts fund manager performance in perspective.

Pre-tax returns vs. post tax returns
As an investor you take home returns net of taxes. Hence, your return calculator needs to factor that in. For example, dividends on equity funds attract DDT of 11.648%, while dividends paid by debt funds attract 29.12%. Here, pre-tax returns can be misleading. Also, when you compare a tax free bond with a taxable bond, then you need to normalize both the investments on post tax basis. For, a taxable paying 8% is the same as a tax-free-bond paying 5.6%, because interest attracts 30% tax. From a financial planning perspective, the post tax returns are a lot more relevant.

Pure returns vs. risk adjusted returns
This is an interesting analysis of how returns are calculated. Let us look at this with an illustration. What is better, a fund that gives 15% returns with 20% standard deviation or a fund that gives 17% returns with 50% standard deviation? Clearly, the second fund is taking on inordinate risk to earn higher returns and it is not worth the higher risk. For mutual funds, there are specific measures like Sharpe and Treynor that are used to calculate risk-adjusted measures. These offer a better base to compare funds.

The next time you look at returns, remember that returns can be a lot more nuanced than you can imagine.

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