- Date : 24/03/2021
- Read: 3 mins
Know about the various types of returns used to measure the performance of investments.
The most important concern we have when investing is the return. The higher the return, the more attracted we are to the investment. Other factors, such as safety and liquidity, are also considered by investors while selecting an asset class. When it comes to returns, there are different types, mostly based on the different methods of calculation. With more clarity about the different types of returns, you will be able to generate more yield from your investments.
Let us look at the common types of returns and how they impact your investments.
Also known as point-to-point return, absolute return is the percentage increase or decrease in an investment over time. However, it is a simple calculation of the absolute return fund that doesn’t consider the duration. Therefore, a high absolute return may not be all that promising as it doesn’t tell you the per-year return. But how to calculate absolute return? Let us consider an example. If you make an investment of Rs 1,000 and it matures to Rs 3,000 in five years, the absolute return formula would be calculated as: 100 x [(3,000–1,000)/1,000] = 200%
Rather than calculating the rate of return over the total investment duration, rolling return averages the smaller period returns. For instance, mutual funds rolling returns will depict the performance journey of the fund rather than the maturity rate of return. Rolling returns are more often used in finding out the consistency of returns rather than absolute growth. So while a three-year rolling return will show the average annual return for the period, a 12-month rolling return will help you find out the performance in the preceding one year. This can be used to measure investment performance at any point during the investment tenure.
Internal Rate of Return
If investments are made regularly, or if you receive a sum from it before its eventual maturity, the calculation of the return on investment can be made using the IRR method. For example, let’s assume that the initial investment of a project is Rs 10 lakh and the return is expected to be Rs 3 lakh annually for five years – but only three years after the completion of the project. It is therefore similar to the use of capital budgeting principles, which considers the present value of future cash. An IRR online calculator can help you find out the rate of return for the project.
Extended Internal Rate of Return
If you need to calculate the IRR, the payments have to be made or received in equal duration. However, if the pattern of payment is irregular, the Extended Internal Rate of Return (XIRR) is the formula of choice. Both IRR and XIRR calculation are also available in Microsoft Excel as a function.
Compound Annual Growth Rate
If you want to calculate the annual positive return rate generated by an investment, CAGR is a popular method. Using CAGR, you can find out the year-on-year rate of return on investment. It helps you smoothen out the fluctuations in the rate in different years. However, a CAGR calculator doesn’t consider aspects like the volatility of the investment or the risk involved in it.
Whether you are judging and selecting an investment based on its return, or checking how an investment is performing, knowledge of the rate of return is important. With more clarity about the different types of returns, you will be able to ensure more astute investment management. Give yourself the magic of compounding. Read more about this magic of finance.