In my previous video, I introduced my favorite financial tool — a CAGR Calculator. Today I’m comparing 3 kinds of returns: Absolute Return vs. Average Rate of Return vs. Compounded Annual Growth Rate (CAGR).
There are more kinds of returns namely: Relative Returns, Risk-Adjusted Return, Rolling Returns, Internal rate of Return(IRR), Extended Internal Rate of Return (XIRR), etc. But I believe Absolute Return, Average Rate of Return, and CAGR are the must-knows.
I have compared all the 3 kinds of returns using the same example. That is, I assumed that you bought a stock at Rs. 1,000 and sold it for Rs. 2,000 after 5 years. And then there’s a Onevestor thing. Because there’s another reason why I made this video and that’s the new Mutual Fund (or rather SIP) culture that’s happening in our country.
1. Absolute Returns
* Absolute Return is simply an asset’s return over a certain period.
* It actually ignores the timeframe.
* For e.g., let’s say you bought a stock for Rs. 100 and sold it for Rs. 200 after 5 years.
* Your absolute return here is 100%.
* Your absolute return is still 100% even if you sold it after 10 years.
2. Average Rate of Return / Simple Annualised Return
* A simple annualised return simply divides the rate or return for the period by the number of years in the investment period.
* It ignores the time value of money.
* For example, suppose an investment returns the following annually over a period of five full years: 10 percent, 15 percent, 10 percent, 0 percent and 5 percent. To calculate the average return for the investment over this five-year period, the five annual returns are added together and then divided by 5. This produces an annual average return of 8 percent.
* CAGR shows how much a person’s investment grew in one year.
* It is the average returns an investor has earned on the investments after one year.
* As you can see, unlike absolute return, CAGR takes time value of money into account. As a result, it is able to reflect the true returns of an investment generated over a year.
* In other words, 1000+14.87%+14.87%+14.87%+14.87%+14.87% = 2,000.014320624
* 1000+20%+20%+20%+20%+20% = 2,488.32
* CAGR is crucial for any asset class. Here’s why.
* Suppose you invested Rs. 1000 in a stock. It gave 100% returns in first year and your stocks value becomes Rs. 2000.
* In second year, it falls 50% and that takes your stock value back to Rs. 1,000.
* Here CAGR and your Absolute Return = 0. But simple annualized return = 50/2=25%
* It represents one of the most accurate ways to calculate and determine returns for individual assets, investment portfolios and anything that can rise or fall in value over time.
* There’s another reason too –– why I explained all above types of returns.
* And it’s the new Mutual Funds (and SIP) culture that’s happening in our country.
* The reason is they are highlighting CAGR as if it’s something that’s guaranteed.
* A Mutual Fund’s CAGR and real return can be totally different.
* For instance, check out the returns of Axis Long Term Equity Fund – Regular Plan (G) — I have personally invested in this ELSS plan.
* So next time when you see that Mutual Fund ad that says “5 year – CAGR of 20%”, just tell yourself that its NAV was NOT moving up 20% every single year.
* Now I guess you know why CAGR is THE most important metric when it comes to investment returns comparison.
Video / Malayalam
I hope you have learned a thing or two from my new video. If so, do share my video with your friends and family on your social media channels!
Happy Investing/Trading! 🙂