Return in simple words helps you estimate the rate at which money grows on a year on year basis. For example, you invest in a property worth 1 Crore and exactly after a year, the value of this property is 1.2 Crore, then the return (or growth rate) is 20%.
However, if exactly after 2 years, the value of this property is still Rs. 1.2 Crore, then the return is no longer 20%, because it is 20% over two years. The common practice is to express returns on an annualized or year on year basis.
The year on year growth rate of return is also called “Compounded Annual Growth Rate” or CAGR. So in the above example i.e 1 Crore growing to 1.2 Crores in exactly two years, the CAGR is 9.54%.
Many people get confused here because they think of it this way - if it is 9.54%, on a yearly basis, then for two years I should have 9.54% + 9.54% or 19.08%, but in reality, I have 20% gains.
This is where the ‘Absolute return’ comes to play.
Absolute return is the return measured without considering time. So I make an investment of 1 Crore today and after 1 year I receive 1.2 Crore, the absolute return is 20%. If after 10 years, I receive 1.2 crore, then the absolute return is still 20%. If after 15 years I receive 1.2 crore, the absolute return is still 20%.
As you can imagine, in the above argument, while the absolute return stands still at 20%, the CAGR varies. Here is how the CAGR contrasts with Absolute Return -
|Time||Initial value of Investment||Initial value of Investment||Absolute Return||CAGR|
Clearly, higher the CAGR, better is the return prospect of the investment you are considering. Also, do note the absolute return can be misleading when you consider it for measuring returns over 1 year.
So when you hear someone say they, “this is a fantastic mutual fund, its return is 25%”, you are safe to assume they are talking about an annualized return aka the growth of this fund on a year on year basis or simply the CAGR.
Finally, remember this in the context of mutual funds - when we make a one-time investment today and after many years you want to measure its return, then you will have to measure its CAGR to get a true sense of its performance on a year on year basis. Absolute return can distort your perception of the real performance of the returns.
A small twist though - for a lump sum investments which is exactly 1 year old, both CAGR and absolute return would read the same value. I hope this is intuitive for you since passage of time is just 1 year here. CAGR kicks in for investments older than 1 year.
There is another kind of return that you will need to know and that is the XIRR or the ‘Extended internal rate of return’. This is a special way of calculating returns applicable when you make multiple investments in the same asset (same fund) over an extended period of time. The typical case here is the SIP investments, where you invest a certain amount of money on certain dates throughout the year.
Think of the XIRR as the CAGR, except its applicable when you make a series of investments in a single asset, multiple times a year.
Here is an example of SIP of Rs.15,000/- on 12th of every month -
As you can see, the total investment across the time period is Rs.195,000. I’ve arbitraily assumed today’s value of the investment as Rs.225,000/-. I’ve also calculated the XIRR for these series of investments, which happens to ve 17.65%.
So all you need to know and remember is this -
CAGR makes sense when you want to know the performance of a fund on a year or year basis. This is also the growth rate of the fund. This is useful to measure return on lumpsum investment across multiple years
XIRR is like CAGR except that its more relevant to SIP investment. Consider XIRR as a special case of CAGR
Absolute return is static, gives you a sense of the overall growth, but lacks the sense of time
Absolute return and CAGR is the same for investments which are exactly 1 year old
So next time you invest, make you measure your returns right !