Understanding Investment Returns - Absolute Returns and CAGR


We invest to earn returns so understanding investment returns is quite crucial to becoming a better investor.

Investment returns can be calculated in different ways.

The simplest way to calculate returns is absolute returns:

Absolute Returns % = (Current Value - Invested Value)/Invested Value * 100

Example: If you invested Rs 10,000 and now its value is Rs 11,000 then your absolute returns % is (11,000- 10,000)/10,000 * 100 % = 10 %

Note that in calculating absolute returns, there is no relevance of the time it took to get those returns. In the above example, the investment of Rs 10,000 could have become Rs 11,000 in 1 year or in 10 years, the absolute returns % remains the same i.e. 10%.

This is what you see as earnings/gains % upfront in your Goalwise dashboard and goal details pages.

absolute-gains

CAGR

However, earning a total of 10% in 1 year is very different and much more preferable than earning the same amount in 10 years. Hence, in order to distinguish the two, we need to measure 'returns per year' or annualised returns. This return calculation is known as CAGR (Compounded Annual Growth Rate).

If absolute returns are like the distance travelled by your investment, then CAGR is the speed with which your investment has travelled or grown.

Conceptually, CAGR = Annualised Returns = Absolute Returns/Investment Duration (in Years)

The above is not the exact formula for CAGR because investment returns are not calculated as simple returns but as compounding returns, but this is good enough for understanding the concept.

Usually when we want to evaluate or compare investments, we want to look at their CAGR because absolute returns will depend on the duration of investments. So in order to compare two investments, one with absolute returns of 12% in 1.5 years and another with 2% in 1 month, you need to compare their CAGR.

A 12% return in 1.5 years is approximately 8% annualised (CAGR) and 2% in 1 month implies a per-year returns or CAGR of 24% (actually even more than that because of the effect of compounding) - very high by any standards! This is something that new investors should keep in mind when evaluating their investments.

Word of caution:

Since CAGR is annualised returns, if you have just started investing, especially in equity funds, and on your first day, the fund's NAV goes up by 1% then your annualised returns will be 1% * 365 days (compounded) which will be an astronomical number.

Same for loss. If you lose 1% on your first day, then your CAGR will be a large negative number (based on a 1% loss everyday for the entire year).

But as we know, neither of these CAGRs will be representative. You will not make 1% everyday for the rest of the year nor will you lose 1% everyday for the rest of the year.

So it will take some time before the CAGR becomes representative of your investment's actual return profile.

To take an example from cricket - if the opening batsman hits a 6 on the very first ball of the innings, the run rate calculated technically will be 36.0

But we all know that a run rate of 36 is not representative and a 'truer' run rate will only be known after a few overs into the game.

Similarly, if no runs are scored on the first ball or even the first over, the run rate is 0 but again it won't be a useful number to go by at that stage.

This is the reason why sometimes when returns are shown for a duration less than a year, they are not annualised i.e. absolute returns are used instead of CAGR when showing returns for less than a year. It's not that CAGR can't be calculated for investments less than a year, it can be calculated but it may not be that useful.

Below is a screenshot from a popular fund information website showing returns over different time frames for a fund. The YTD (year-till-date), 1-month, 3-month and 1-Year returns are all absolute returns whereas 3-Year, 5-Year and 10-Year returns are all CAGR (annualised returns).

VRO-returns-data-1

SIP returns or Generalised CAGR (XIRR)

In case of SIP or even multiple lumpsums, many times absolute returns number might seem a bit low, especially for investors just starting out. The reason is that your money has been invested over time and not all at once.

For eg in case of a SIP of Rs 10,000 for an year, only the first 10,000 is invested for the entire year, the next 10,000 will be invested for only 11 months, the one after that for only 10 months and so on with the last 10,000 being invested for just one month.

This is very different from investing the entire Rs 1.2 lakhs in one go right at the start for the entire year.

In this case, the CAGR calculation considers each investment separately to come up with an overall annualised returns % that would have grown the periodic investments to their current value given their individual investment durations.

This kind of generalised CAGR calculation is also referred to as IRR (Internal rate of return) or XIRR. Different terms are prevalent in different contexts, but the concept is the same.

You can see this generalised CAGR calculation on your Goalwise dashboard as well.

CAGR

For evaluating how your investments are doing, look at the CAGR, not absolute returns, especially if you have been investing for more than a year.