Investing in mutual funds, stocks, or other assets often comes with the challenge of evaluating performance.There are two main methods to determine the return on investment: CAGR and absolute returns. XIRR is basically CAGR for SIP based investments. The names will seem alike but are applied quite differently and provide varying information on the outcome of investments.This blog will break down both these terms, highlight their differences, and help you understand when to use each in your investment journey.
What are Absolute Returns in a Mutual Fund?
Absolute return is the total return from a mutual fund from the date of investment. Often, absolute returns are quoted as a percentage value that indicates growth or devaluation in investment value.
Absolute returns are pure returns from the investment and, therefore, do not compare with any other benchmark. Moreover, absolute returns can be either positive or negative. Mutual funds use various methods, like short selling or derivatives, to bring about a positive return for the fund managers.
While calculating absolute returns, the tenure of investment is the least important. Only actual investment and the current value of the investment are considered while estimating the absolute return.
Absolute returns are pure returns from the investment and, therefore, do not compare with any other benchmark. Moreover, absolute returns can be either positive or negative. Mutual funds use various methods, like short selling or derivatives, to bring about a positive return for the fund managers.
While calculating absolute returns, the tenure of investment is the least important. Only actual investment and the current value of the investment are considered while estimating the absolute return.
Formula for calculating Absolute Return
Example: A mutual fund investor invested ₹ 2,00,000. After some period that investment grows to ₹ 6,00,000. To obtain absolute return we apply the formula:
Absolute Return = [(600000 / 200000) – 1] * 100%
The absolute return in this situation is 200%. The time duration of the investment is completely ignored while computing absolute returns. Perhaps this 200% growth happened over a few months, several years, or even decades. Therefore, absolute returns alone can never decide whether it is a good investment or not because this will not reflect the duration of investment.
Basically, absolute returns only give the magnitude by which an investment has appreciated or depreciated. This doesn’t help indicate at what speed the investment grew or declined. Thus, absolute returns are not suitable for comparing two different investments.
Absolute Return = [(600000 / 200000) – 1] * 100%
The absolute return in this situation is 200%. The time duration of the investment is completely ignored while computing absolute returns. Perhaps this 200% growth happened over a few months, several years, or even decades. Therefore, absolute returns alone can never decide whether it is a good investment or not because this will not reflect the duration of investment.
Basically, absolute returns only give the magnitude by which an investment has appreciated or depreciated. This doesn’t help indicate at what speed the investment grew or declined. Thus, absolute returns are not suitable for comparing two different investments.
What is CAGR?
CAGR, or compound annual growth rate, is an annual rate of return of an investment over a stated period of time measured as a percentage. In simple words, it is the theoretical growth rate at which an investment would rise steadily on a year-over-year compounded basis.
CAGR does smooth out fluctuations in the returns on investment over time, and it is the most helpful tool when one wants to compare investments with different returns earned over different periods. Long-term CAGR will help investors study the future growth potential of an investment since it dampens the effects of short-term volatility of the market.
CAGR does smooth out fluctuations in the returns on investment over time, and it is the most helpful tool when one wants to compare investments with different returns earned over different periods. Long-term CAGR will help investors study the future growth potential of an investment since it dampens the effects of short-term volatility of the market.
Formula for calculating CAGR
The CAGR calculation is slightly more complicated than the absolute returns’ computation. The formula for CAGR is stated below.
Let’s take an example to understand CAGR in a better way. An investor invested ₹2,50,000 as a lump sum in a mutual fund. After three years, the investment has grown to ₹5,00,000. We will use the formula to calculate the CAGR for this investment.
CAGR = [(500000 / 250000) ^ (1 / 3)] – 1 CAGR = 0.2599 or 25.99%
This means the investment grew at an annual rate of 25.99% over the three-year period to reach ₹5,00,000. In other words, the average return from this mutual fund is 25.99%. The absolute return from this investment is 100%, but the CAGR is 25.99%.
CAGR = [(500000 / 250000) ^ (1 / 3)] – 1 CAGR = 0.2599 or 25.99%
This means the investment grew at an annual rate of 25.99% over the three-year period to reach ₹5,00,000. In other words, the average return from this mutual fund is 25.99%. The absolute return from this investment is 100%, but the CAGR is 25.99%.
Absolute Returns vs CAGR
Investment is carried out with an aim to earn or gain. Return from investment can be represented in many ways. Absolute return is one of the basic ways which may be considered easy and helps to calculate the return from investment. The return is independent of the time or period of investment. Absolute return only takes into consideration the principal amount as well as maturity amount. The compounded annual growth rate takes into account the tenure or period of investment. It is thus more accurate and comparable in terms of earnings percentage.
Key Differences Between Absolute Return and CAGR
What is XIRR and how is it different from CAGR?
XIRR (Extended Internal Rate of Return) is a more accurate way to calculate returns for investments with irregular cash flows, such as those made through systematic investment plans (SIPs) or real estate projects. XIRR considers the timing and amount of each cash flow, including when money is added or withdrawn.
Your choice between absolute returns and CAGR largely depends on the time frame and nature of your investment:
Short-Term Investments: If you are evaluating short-term investments (less than a year), absolute returns provide a quick and straightforward way to understand your profit or loss.
Long-Term Investments: For investments spanning multiple years, CAGR is a better tool. It provides an annualized rate of return, accounting for the effect of compounding. This makes CAGR particularly useful for comparing different investments or funds over the long term.
Performance Comparisons: When comparing the performance of various investment options (e.g., mutual funds, stocks, etc.), CAGR is generally preferred. It neutralizes the effect of different time periods and gives a clear picture of which investment has grown faster on an annual basis.
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