Suppose you’re an investor, you need to calculate your results. Without reviewing your results, compared to the previous time frame's results, you cannot tell your investment is good or not. Without calculating returns, how will you know that your returns are better than the market's average returns or better than your previous year?
Table of contents
Understanding returns
By definition: A return is a change in the price of an asset, investment, or project over time, which may be represented in terms of a price change or percentage change. A positive return represents a profit while a negative return marks a loss.
The yield created by an investment over a period of time is referred to as "return." It's the percentage gain or decline in the investment's valuation over the time frame.
Returns are mostly calculated on an annualized basis, which means it's calculated on a year-on-year basis. In terms of the stock market, it's calculated till the day you’re holding your investments. These investments also include the dividends, interest, rights, benefits, and other cash flows you get while you're holding your investments.
Nominal Return
Nominal Returns are what an investment generates before taxes, fees, and inflation. It is simply the net change in price over time. If an investment generated a 10% return, then the nominal return will be 10%, while the actual will be lower.
The nominal rate of return has its merits as it allows investors to compare the performance of an investment irrespective of the different taxes, fees, inflation, etc that might be applied for each investment.
Actual Return
Actual returns are also called real returns. These are generated after adjusting taxes, fees, and inflation. In most cases, investors pay different amounts of tax based on the investment, how long the investment was held, and the investor's tax bracket.
To bring a perspective to all IT professionals. The package you get will be 8.5 LPA. But it doesn’t mean you will be getting 8.5 L/12 months in your hand every month. This is the total amount including your insurance, taxes, PF, HRA, etc. Basically, you in hand will be much less and it widely varies from company to company. Thus, the actual return varies significantly from the nominal return.
Inflation
In economics for inflation, we say, the value of money today will not be equal to the same amount in the future. This is also called the time value of money.
Inflation can be said as the rate of increase in prices over a given period of time. By looking at the below chart you can see how different commodities/goods increased in their prices over time. The point here is, if you had 100 rupees then (1997) you had a lot, but if you have 100 rupees now (2021), that is not a lot.
Inflation is a broader term, which explains the increases in prices of all the goods and services, typically the cost of living. But it can also be more narrowly calculated-for certain goods, such as food, or for services, such as a haircut, for example. This tells us, how much expensive the relative goods have become over a certain period of time.
To calculate this inflation, the government conduct surveys on common household goods and services over a period of time. These household goods and services are together they put it under a basket called consumer basket. The cost of this basket at a given time expressed relative to a base year is the consumer price index (CPI), and the percentage change in the CPI over a certain period is consumer price inflation, the most widely used measure of inflation. For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period.
To bring you a perspective, our current inflation rate is around 3.5%. This means, every year, the price of goods increases an average of 3.5%. An interesting fact to be noted here is, although the inflation rate is increasing year on year, the salary a person is getting is not increasing.
Rather we can say, the base salary a person gets when he gets into a company has remained the same for the past 15 years. In terms of multinational IT companies, the fresher joining package was around 3.2 LPA in the year 2009 and in the year 2021, the fresher joining package is around 3.4 LPA.
Absolute Returns
Absolute return is the percentage difference between your initial investment to the final returns you get from the investment. Here you do not include the time factors when calculating your returns. Suppose you invested 100 rupees in the year 2018 and your investment stands at 110 as of 2021. Your absolute return, in this case, will be 10%.
This is mostly used to calculate returns over a term of less than a year. The time of keeping the fund is unimportant in this process.
Annualized returns
In Annualized return, we see how the investment performed year after year. We will be taking the time factors while calculating annualized returns. Compound annual growth rate (CAGR) refers to the compounding of returns over time. This is the most widely used calculation to measure your investment over a period of time shown in percentage.
It is expressed as a percentage, that represents the cumulative effect that a series of gains or losses has on an original amount of capital over a period of time. It gives investors a preview of an investment's results, but it doesn't tell them how volatile it is.
So, when we are calculating compounding, we say, the initial fund has been compounded over a period of time. For example, an initial investment of 100 has become 161 at the end of 5 years. In terms of absolute value, the percentage difference is 61% returns, but 5 years is not taken into consideration. But in terms of compounding, the amount of 100 has compounded at the rate of 10% year on year. We say the CAGR is 10%.
To know more about compounding, see the article on The power of compounding in the stock market.
In the stock market, our indices usually have a CAGR of 10%. What we mean here is, NIFTY 50 grows at the rate of 10% every year. If Nifty was 100 today and 5 years later nifty should ideally be 161, showing a CAGR of 10%.
For super calculated investors like Rakesh Jhunjhunwala, his CAGR normally grows above 24% year on year. All the mutual fund managers always try to beat the index CAGR which is around 12%.
To bring a perspective, our yearly inflation rate is 3.5% year on year while our Fixed deposit rate in banks is 5%. This means, after the adjustment of inflation, you are with only 1.5% growth of your capital year on year if you choose to put your money in the bank. If you have put 100 rupees in the bank for FD, you will get 5 rupees in return from the bank, but inflation will eat away 3.5 rupees of your gained 5 rupees. Thus, practically you will only be left with 1.5 rupees.
Conclusion
Always, keep in mind the effect inflation that has on our life. This not only affects financially but also the fundamentals of psychology. Suppose you are delaying buying something today, you will have to remember that in coming years, the price you see today will not be the same. You can see this price hike everywhere around us, right from petrol, vegetables, cars, etc.
In the article above I have mentioned how people compare their investment to market indices. So, you must be wondering what these indices are and why they have a big role to play. In the next article, we’ll explore market indices.