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Key to Financial Success -Understanding How Return on Investment Works

Updated: Nov 20, 2023

Table of Content:

Return on Investment

Introduction

A problem that investors frequently encounter is determining the possible gains that they can make from different financial instruments. We call this process of determining an investment's profitability as “Calculating the Return on Investment” (ROI). For market investors, ROI is the ultimate objective since it acts as a lighthouse to help them make wise investment choices.

But here's something that is just as important as the ROI itself - realising its significance and understanding its different measures.

Why Quantify Returns?

Initially, it might seem adequate to just look at the precise returns offered by investment options and make decisions based on those findings. This strategy is not without its drawbacks, though. Standardisation of actual returns is not applied to all investment values. Therefore, a definitive "percentage" that represents returns from a particular project for all investment amounts is required. We recognise this "percentage" as the way that return on investment is quantified. Let's use an example to demonstrate this.

Consider the example of an investor who puts Rs. 8,000 and Rs. 25,000 into different financial instruments. The investments yield 8,400 and 26,750 rupees, respectively, after a year. The real returns come to 1,750 and 400 rupees. At first glance, it could seem like the second instrument is a better option because it offers higher returns. However, because of the different initial investment amounts, this conclusion is deceptive. We should calculate the returns in terms of percentages so that we can compare them accurately. For the aforementioned investments, the yearly rate of return is 5% and 7%, respectively.

For each investment value in that particular tool, these "percentages" serve as the benchmark. Assuming the investor's risk exposure is the same for both, it streamlines the decision-making process.

Examining Different Return on Investment Measures

Now that the significance of calculating return on investment has been established, let's examine the various approaches that can be used to do so. These methods are especially helpful for mutual funds because they give you a clear picture of whether or not to invest in a specific plan.


The various techniques used to calculate return on investment are listed below, along with the situations in which they work best:

1. Absolute Returns

Calculations of returns on investment are made using different relationships and durations. The total return on your initial investment is represented by absolute returns.

Assume that an investor invests Rs. 15,000 in a fixed deposit and receives Rs. 22,500 in total after five years. In this instance, 50% of the initial investment, or Rs. 7,500, represents the absolute returns.

2. Annualised Returns

Absolute returns are rarely used to calculate investment returns since it obscures the true capital appreciation and lacks a time horizon. Hence we have annualised returns - which accounts for the time value of money, they provide a more transparent view of investment returns.

To compute annualised returns, you must first ascertain the total return for the duration of the investment period in order. Divide the total return by the number of years in the investment period. Lastly, this average annual return is expressed as a percentage of the initial investment.

Think about a five-year investment that increases from Rs. 12,000 to Rs. 18,000 in value. In this case, to calculate the annualised return of an investment, over five years, the total return is found, divided by five (the number of years), and expressed as a percentage. This yields an annualised return of 10.15%. This figure actually paints a clearer picture than the absolute returns of 50%.

3. CAGR (Compound Annual Growth Rate)

A great metric for figuring out annualised returns is CAGR. It is the annual rate of return that drives an investment from its starting point to its end value. The amount invested initially, the investment's final value, and the length of time it has been held are required to compute the compound annual growth rate, or CAGR.

The following is the formula for CAGR:

CAGR =( (EV/BV)1/n -1 ) *100 Where: EV = Ending Value BV = Beginning Value n = Number of Years

This formula can be used to determine the CAGR, for instance, if an investor wants to know the interest rate needed to grow an investment from Rs. 10,000 to Rs. 20,000 over a five-year period. In this instance, the investment's CAGR comes out to be 14.87%.

4. Price Returns

The difference between an investment's initial and final values is referred to as price return. It only takes into account the capital growth of your investment for a particular investment portfolio; dividend returns and interest income are not taken into account.

For instance, if you invest in a mutual fund with a Net Asset Value (NAV) of Rs. 15 and the NAV increases to Rs. 16 after a year, the value of the price returns is 6.67%.

5. Total Returns


When calculating investment returns, the Total Returns method makes the assumption that dividends are reinvested as soon as they are declared. It takes into account not just price returns but also the income from interest and dividend distribution.

For mutual funds with growth options, where dividends are reinvested, total returns, not price returns, should be used to calculate returns. In other words, if the fund's NAV is Rs. 20 when you purchase units and it is Rs. 22 after a year, the total returns—which include the 12% reinvested dividends—provide a more complete picture.

In Comparison…

​Types of Returns

Description

Scenario

Absolute Returns

Absolute Returns

Total gain on initial investment.

useful for assessing returns over specific durations

​Annualised Returns

Annualised Returns

considers the time value of money, providing a clearer picture.

Preferred for analysing investments with a time horizon

CAGR

CAGR

Represents the annual return rate needed to grow an investment from its initial to its final value.

Useful for understanding the growth of investments over time.

Price Returns

Price Returns

Focuses on capital appreciation,excluding dividend returns or interest income.


suitable for evaluating the capital growth of an investment.


Total Returns

Total Returns

Includes reinvested dividends, interest income & price returns.

Ideal for measuring returns in growth-oriented investments.


In Conclusion…

Continually measuring return on investment (ROI) should be an integral part of an investor's financial planning. A thorough understanding of the above methods will aid in making well-informed financial decisions and deciding when to shift your investment to other saving vehicles.

Empower Yourself with Tools

If you are a mutual fund distributor, in your quest for optimal investments, you should consider incorporating cutting-edge tools like AssetPlus into your strategy. AssetPlus empowers you with technology, training and support essential for successful distribution. By leveraging its resources, you not only enhance your efficiency but also provide your clients with superior service, cementing your position as a trusted financial advisor.

Armed with knowledge, guided by the right tools and supported by robust technology like AssetPlus, your journey as a mutual fund distributor can be immensely rewarding.

Help others build wealth while you build your own financial empire. Here’s to your prosperous future in the world of mutual fund distribution!


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