Using the correct benchmark while measuring returns will help arrive at a better decision.
Investments are made to earn returns. An obvious question that arises is how to compute the 'returns' or what 'return' really means. Let us take a closer look at these.
How should we conclude that a particular rate of return is good or not? This can be done if we are able to compute the return and match these with comparable/alternate investments.
Investment return is the change in value of an investment over a given period of time. It has two basic components. There is interest and/or dividends, the income generated by the underlying investment. And, appreciation, an increase in the value of the investment. There are many methods to calculate returns. Here's where it gets a little fragile and, at times, the financial advisors and analysts pitching for investments can take liberties on the concept of returns. Returns can be expressed in different ways.
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Let's understand how investor returns are calculated.
Absolute return: Absolute return is the increase or decrease expressed in percentage terms that an investment achieves over a given period of time. Let's say you invested in stock at Rs 50 on June 16, 2009; it appreciated to Rs 60 by June 15, 2010. The absolute return in this case is 20 per cent. The index S&P CNX Nifty has increased from 4,518 as on June 16, 2009, to 5,222 as on June 15, 2010, an absolute increase of 15.58 per cent.
Simple annualised return: The increase in value of an investment, expressed as a percentage per year. Today's Rs 1,00,000 investment appreciates over three years to a little over Rs 1,24,000. The absolute return on that investment is 24 per cent. However, the simple annualised return is 8 per cent, i.e. 24 per cent divided by 3.
Compounded annual growth rate (CAGR): A better assessment of return in the case of longer duration investment is the CAGR. It is a useful tool when determining an annual growth rate on an investment whose value has fluctuated widely from one period to the next. CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. CAGR is a way to smoothen out the returns. The table below provides the CAGR of S&P CNX Nifty for various time periods:
| Period | S & P CNX Nifty | CAGR (%) |
| 3-year | 4,171 | 7.77 |
| 5-year | 21,291 | 9.65 |
| 10-year | 1,445 | 13.70 |
Relative return: Relative return is the difference between the absolute return achieved by the investment as compared to the return achieved by the benchmark. For example, if the stock you are holding achieves an absolute return of 20 per cent, while the benchmark index (e.g. S & P CNX Nifty) managed 15.58 per cent, then the stock has achieved a relative return of a positive 4.42 per cent. A stock that falls less than the benchmark in a falling market is considered to have done well, as it manages to contain losses for the investor.
Relative returns enable us to know the true return earned by the fund over and above the market-linked returns.
Peer returns: Suppose you invest in SBI and the stock increases in a year by 25 per cent. Other banking stocks rise, too —ICICI Bank by 22 per cent, PNB by 20 per cent and HDFC Bank by 18 per cent. It means SBI has given better returns as compared to its peers. Peer return helps in stock selection within a particular sector or sub-group of an asset class.
Risk adjusted return: The risk-adjusted return of an investment is the return it provides, adjusted for how risky it is. Risk-adjusted return is calculated using the Sharpe ratio, a volatility-adjusted measure of return. To calculate risk-adjusted return, subtract the risk-free rate from the investment's return, then divide the resulting number by the standard deviation of the investment's return. The value of a risk-adjusted return lies in its ability to reveal whether an investment's returns are attributable to smart investing or excessive risk-taking. Risk-adjusted return is a useful tool for factoring volatility into investment decisions. The concept is very popular while comparing the returns from equity mutual fund schemes. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.
Investment returns can be stated as absolute return over a particular period of time. Or, they might be stated as an annualised return equivalent. It's very common to use absolute return for a shorter period of time such as a month or a quarter. Annual return is the more acceptable way to state returns for time periods greater than a year. Risk-adjusted and peer returns are very relevant to mutual funds.
To determine the performance of your investment, you should make regular calculations on its return. Many investors ignore this important aspect of monitoring investments. Investors should understand how investment returns are calculated and which return to consider for making investment decisions. Awareness about calculating the returns from investment is essential to be a smart investor.
The writer is a freelancer
