How To Estimate Returns From Investment?

CAGR, Absolute Return or XIRR. Which one do you trust the most?

Every investor desires high returns. Not to put too fine a point on it, but most investors are solely concerned with the return. The math behind returns is frequently difficult to grasp, especially for those with no financial background. Depending on how you calculate the returns, the true picture of your investment performance is revealed.

Compounded Annual Growth Rate (CAGR)

CAGR calculates how your investments have performed each year over multiple years. Certainly, no investment achieves the same growth rate each year. Positive and negative values are both possible. CAGR reveals exactly how much your investment grew annually.

Let’s look at an example to understand CAGR better. If you invest Rs. 2.5 lakh in stocks and watch it grow to Rs. 4.5 lakhs after five years, your CAGR is 12.47 per cent, i.e. 12.47 per cent annual growth rate on your investment. Remember that this does not imply that your investment has grown at this rate every year for the past five years.

Absolute Return

Absolute return is calculated by comparing the final value of your investment to the original cost of your investment. Assume you invested Rs. 5,000 in a mutual fund five years ago, and it is now worth Rs. 6,000. You gained Rs. 1,000 in total profit or a 20% return on your initial investment.

A 20% return may appear to be attractive on the surface, but when viewed through the prism of CAGR, it works out to an annualised rate of 3.7%, which is comparable to savings bank interest rates. This essentially means that absolute return does not represent the true return on investment. In this case, the CAGR represents the true performance of your investments.

Extended Internal Rate of Return

Investments involving multiple transactions at different times necessitate the application of the XIRR. Whether you invest in a mutual fund via a systematic investment plan (SIP) or a lump sum, XIRR will provide you with the exact annual returns made over the entire investment period. One can say CAGR is more precisely calculated as XIRR.

An example is provided to help you better understand XIRR. Assume you invest Rs 10,000 in an equity fund on a monthly basis for a period of 12 months. Each SIP instalment will be done at a distinct NAV. Your total investment value at the end of the year is Rs 1.32 lakh, versus a capital investment of Rs 1.20 lakh. This means that the investment has increased by 10% in a year. However, this is an incorrect conclusion because the Rs 1.20 lakh investment was spread over 12 months. Even CAGR will not reveal the entire picture. In this case, the XIRR can be used to calculate the exact return.

The three methods for calculating returns discussed above will produce different results. It is safe to conclude that XIRR is the most accurate number to evaluate the true performance of your investments.

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