Thursday Trivia ~ Why 12% can be better than 50% – Understanding Different Kind of Return Calculations

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Thursday Trivia ~ Why 12% can be better than 50% – Understanding Different Kind of Return Calculations

It’s a nice Sunday morning, while Suresh is sipping his coffee with his wife. It’s been quite some time that both of them have been considering investing their money. But as it’s usual for professionals these days, weekdays just zip pass, Saturdays are spent in covering up sleep for the week while Sunday is planned for family and few close friends (some of them even meet once a year despite living next door). Hence, a Sunday morning sounds like a perfect idea to discuss about investments. Suresh has been actively looking up the internet and newspapers to understand which would the best instrument to invest his money in. Hence, his first and foremost criteria is ‘returns’. With his education background being non-finance, he is just shocked with so many types. It’s not just the story of Suresh, it’s about most people regardless of any education background they have come from. Most of us just get overwhelmed by so many types of returns and by thumb rule we go in for a number which is highest without trying to understand what it actually means.

In this Trivia, we discuss about these various types of ‘Returns’.

Absolute Returns

It is the return that an asset achieves over a certain period of time.

In the real estate market, investments are always mentioned on ‘absolute return’ basis. A house when purchased 10 years ago at Rs. 1 crore has grown to a value of Rs. 2 crores. Which is 100% absolute return. It sounds like music too. Who wouldn’t like 100% increase in their investment value.

Also, just a food for thought. How often time factor is discounted during such conversations as well?

Simple Annualised Returns

Taking cue from the above example, if 100% return arrived in10 years will make a simple annualised return of 10% assuming the money has been growing at a constant rate. Somehow, talking about 10% annualised growth doesn’t sound as exciting as 100% absolute return growth. This actually happens when most people are looking for investment options.

Simple Annualised Returns are important to note since we are designed to look at investment returns with a maximum horizon of 1 year. On a similar note, it is important to look into one of the most common methods used in describing returns on investment mentioned below – CAGR.

Compounded Annual Growth Rate (CAGR)

Put simply, CAGR works on the principle of interest on interest. When computed on the basis of a house of Rs. 1 crore, a 10% increase on the same would result in Rs. 1 crore and 10 lakhs. For compounding to work, Rs. 1.10 crores would be taken as base and next year’s 10% increase in price would result in Rs. 1 crore and 21 lakhs. On a total of 10 years, CAGR works out to 7.2% for that specific real estate to become Rs. 2 crores.

When, a certain investment has some form of cash flow, it maybe inflow or outflow, returns are calculated on the basis of XIRR.

So now, we have 3 numbers with us – 100%, 10% and 7.2%. Fun of the fact is that all three have given the same form of returns with different mathematical characteristics. Although, often times 7.2% CAGR is neglected and 100% absolute returns is looked into.

However, it becomes important to note that a number computed on the basis of CAGR will not mean that the return is less. While comparing two investments, if one has 50% absolute returns while the other has 12% CAGR, it makes more sense to notice that 12% number. Since, over the period of 5 years, 12% CAGR will yield more investment returns than 50% absolutely returns. Therefore, it’s always advisable to compare investments from the framework of CAGR.

Incase, you need clarity in computing CAGR returns, do write to us.

To summarise, the above terms discussed may sometimes look similar and sound confusing too. In that case, do contact your financial advisor and learn the difference between the same. As the title mentions, 12% CAGR returns are more sweeter than 50% absolute returns.

– Jinay Savla


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