The simplest is the average annual return, the arithmetic mean of the returns earned over a period. It is prone to be the most misused indicator, to show unrealistic returns. Let us say you invest `100,000 in a mutual fund (MF).
At the end of the first year, the growth is 100 per cent and at the end of second year, a fall of 50 per cent. At the end of two years, you have not gained anything. But, the average annual return method will show net return of 25 per cent.
When the gain or loss in a portfolio is expressed as a percentage of the invested capital, it is known as the absolute return. is calculated as the difference of current value and cost value, divided by cost value, which is 64.14 per cent. But, this does not take into account that this return has been earned over more than a year.
If the holding is for over a year, we usually look at the compounded annual growth rate (CAGR). This gives you the year-on-year returns. The formula is ((F/S)^(1/n))1. F = Final value, S = Initial value and n= holding period. In the table, CAGR is 22.65 per cent. It is assumed the gains are reinvested every year. So, the investment grew to `122,646 in first year, 150,422 in second year and `164,136 at the end. But this might not be true.
The fund may have fallen drastically in one year and given excellent returns the next year. CAGR smoothens the returns and does not considering volatility over the holding period. But, it does make returns comparable across funds.
In case of a series of cash flows for which the rate of return is to be calculated, XIRR is used. This considers the timing of inflow and gives a better picture than CAGR. It is useful in calculating the rate of return for investments like SIPs.
XIRR is 25.25 per cent. Here, most investors would calculate the return as 13.33 per cent. That's incorrect as the method does not take into account different timings of each cash flow. Again, it is assumed the cash is reinvested at the same rate. But, the rates fluctuate and may not be available when reinvesting.
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