Decoding Investment Returns: Metrics That Matter

Investing in mutual funds is a widespread method for increasing one’s wealth. However, the returns generated by investments are not always straightforward, as there are various types of returns to consider. Understanding the different types of returns and how to calculate them accurately is vital for investors to make informed investment decisions and accurately assess their portfolios’ performance.

The most basic form of understanding investment returns is the absolute return. It measures the percentage increase or decrease in the investment’s value from the initial investment without considering other variables such as time, money, or weight. However, this metric does not take into account the duration of the investment or the cash flows generated by the investment.

Annualized return is a more comprehensive return metric that measures the average rate of return per year, assuming the investment achieved the same return rate consistently over the measurement period. This metric is widely used by investors, as it considers the duration of the investment and the compounding effect of the returns earned over time.

Another crucial return metric is the Internal Rate of Return (IRR). It considers the time value of money and the cash flows generated by the investment. IRR calculates the discount rate that equates the present value of the investment’s cash inflows to the present value of its cash outflows. This return metric is essential for evaluating the performance of an investment and comparing different investment opportunities.

Let’s explore the different types of returns investors can expect from their investments and how to calculate them accurately. We will delve deeper into each return metric and provide examples to help investors understand the concepts better. By the end of this article, investors will have a clear understanding of how to evaluate the performance of their portfolios and make informed investment decisions.

Absolute Return

When investors evaluate their investments, they typically begin by calculating the absolute return. Absolute return is the profit or loss from an investment without considering any other variables such as time, money, or weight. In other words, it measures the percentage increase or decrease in the investment’s value from the initial investment, irrespective of the time frame.

The calculation of absolute return is simple. It is calculated by subtracting the initial investment’s value from the current investment’s value and then dividing it by the initial investment’s value. The result is then multiplied by 100 to express the return as a percentage. For example, if an investor initially invests Rs 1,000 in a stock and the value increases to Rs 1,200 at the end of the investment period, the absolute return is 20% calculated as (1200-1000)/1000 * 100.

While the absolute return provides investors with an easy way of understanding their returns, it does not provide a complete picture. It does not consider the time value of money, compounding, or the period over which the investment generated the returns. For instance, two investments may have the same absolute return, but one may have taken 10 years to achieve the return, while the other took only one year. Therefore, absolute return should be used in combination with other return metrics to evaluate the investment’s performance accurately.

Annualized Return

Annualized return is a return metric used to evaluate the investment’s performance over a more extended period, regardless of the timeframe used to measure the returns. Annualized return is calculated by determining the average rate of return per year, assuming the investment achieved the same return rate consistently over the measurement period.

The calculation of annualized return involves a simple formula: ((1+return)^n)-1, where n represents the number of years. For instance, if an investment had a 10% absolute return over a month, the annualized return would be approximately 214% calculated using the formula ((1+0.10)^12)-1. The formula assumes that the investment achieved the same rate of return every month over the year, compounding the returns over the period.

Annualized return is significant because it accounts for the time value of money and the compounding effect. It provides a better understanding of the investment’s performance over a more extended period, regardless of the timeframe used to measure the returns. This helps investors to compare investment opportunities more accurately and make informed investment decisions.

For example, suppose an investor invested £5,000 in a mutual fund and received an absolute return of 20% over three years. The annualized return would be approximately 6.14%, calculated using the formula ((1+0.20)^(1/3))-1. This means that the investment returned an average of 6.14% per year over the three years.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is a return metric used to evaluate the performance of an investment, taking into account the time value of money and the cash flows generated by the investment. IRR is the discount rate that equates the present value of the investment’s cash inflows to the present value of its cash outflows.

The calculation of IRR can be complex, but it can be done using various financial software or spreadsheets. In general, IRR is calculated by setting the net present value (NPV) of the cash flows generated by the investment to zero and then solving for the discount rate that makes the NPV equal to zero. The cash flows used in the calculation are the investment’s initial outflow, followed by all subsequent inflows, and the final cash inflow from the investment.

IRR is significant in investment analysis because it considers the time value of money and the cash flows generated by the investment. It helps investors to determine the rate of return the investment has generated over the investment period. Furthermore, IRR can be used to compare investment opportunities with different cash flows and investment horizons.

For example, suppose an investor invests Rs 10,000 in a project that generates a cash inflow of Rs 2,000 at the end of year one, £4,000 at the end of year two, and Rs.8,000 at the end of year three. Using the NPV formula, the investor calculates the project’s NPV to be Rs 2,400 at a 10% discount rate. The IRR for this project is approximately 28%, which is the rate that makes the NPV equal to zero.

Investors often ask, “What returns am I making on my investments?” Understanding the different types of returns and how to calculate them accurately is crucial for investors to make informed investment decisions and assess the performance of their portfolios accurately. Absolute return measures the percentage increase or decrease in the investment’s value from the initial investment, while annualized return measures the average rate of return per year, assuming the investment achieved the same return rate consistently over the measurement period. Internal Rate of Return (IRR) is a more complex return metric that considers the time value of money and the cash flows generated by the investment.

Investors should not solely rely on one return metric when evaluating their investments. Instead, they should use a combination of different return metrics to get a more comprehensive view of their portfolio’s performance. By understanding these return metrics, investors can make informed investment decisions and assess the performance of their portfolio accurately.

To wrap up, the world of investing can be complex, but understanding the different types of returns and how to calculate them accurately is an essential step toward achieving financial success. Whether investing in mutual funds or other types of investments, investors should always consider the different return metrics and make informed decisions based on their investment goals, risk tolerance, and time horizon.

Contact us today to get your investment journey started.