When you invest your money, you want it to grow. But how do you measure the growth of your investment? There are two common metrics used to measure investment returns: absolute return vs annual return. While making your investment decisions, comprehending these two investment metrics properly becomes significant for achieving your financial goals. This article will discuss the differences between Absolute Return vs Annual Return, their significance, and how they can impact your investment strategy.
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Absolute return is the percentage of actual gain or loss an investment generates over a specific period with respect to the initial investment amount. This metric does not depend on the performance of the market or other benchmarks. This means that an absolute return investment can still generate positive returns even if the market is declining.
Absolute Returns = ((Present NAV – Initial NAV)/ Initial NAV) × 100
For Example: If you invest in ICICI Prudential BlueChip Fund
Lump sum investment in the fund= Rs. 5000
Period of investment= 5 years
The value of your investment becomes= Rs. 6000 (after 5 years)
Your Absolute Return= ((6000-5000)/5000) × 100
Reason: The value of your initial investment has grown by 20%, regardless of whether the market has gone up or down during this period.
Absolute return investments can be a good option for you if you are looking for a way to generate positive returns in all market conditions. However, it is important to note that investments made on the basis of absolute return can also be more volatile than traditional investments.
Annual return, also known as Annualized Return or Compound Annual Growth Rate (CAGR), is a measure used to calculate the average rate of return on an investment over a specific period, typically one year. It allows you to understand the average annual growth rate of your investment.
It considers the starting value, ending value, and the time elapsed during the year. It is expressed as a percentage and represents the annualized growth or decline of the investment.
CAGR provides a way to express the average yearly performance of an investment, taking into account compounding effects.
Annualized Return (CAGR)
= ((1 + Absolute Rate of Return) ^ (365/no. of days)) – 1
= ((1 + Absolute Rate of Return) ^ (1/no. of years)) – 1
= ((Present NAV/ Initial NAV) ^ (1/no. of years)) – 1
For Example, If you invest in ICICI Prudential BlueChip Fund
Lump sum investment in the fund (on 22 July 2023)= Rs. 1 lakh
Fund NAV (on 22 July 2023)= 20.04
No. of units purchased= 5000
Investment period= 5 years
If you redeem your fund on 22 July 2028:
Selling price of your fund value= Rs. 1.51 lakhs
Total profit= Rs. 1.51 lakhs – Rs. 1 lakh
= Rs. 51,000
CAGR = [(1,51,000/1,00,000)^⅕ ]– 1
Your Annual Return (CAGR)= 8.5%
NOTE: In the same way, you can calculate the annualized return for 3/ 6/ 7/ 10 years.
*Use the CAGR calculator to estimate your annualized return over a period.
Annualized return is particularly useful when comparing the performance of different investments. It is also useful to forecast future returns or to consider long-term investment strategies.
NOTE: It is important to remember that past performance is not necessarily indicative of future results. The CAGR metric also does not take into account fund volatility.
Let us understand the difference between absolute return and annual return from the table mentioned below:
|Particulars||Absolute return||Annualized return|
|Definition||The total percentage change in the value of an investment over a specific period, without taking into account the effect of compounding.||The average rate of return per year over a specific period, taking into account the effect of compounding on the investment returns.|
|Calculation||((Present NAV – Initial NAV)/ Initial NAV) × 100||((Present NAV/ Initial NAV) ^ (1/no. of years)) – 1|
|Accuracy||Typically less accurate than annualized return, as it does not factor in compounding.||Typically more accurate than absolute return, as it factors in compounding.|
|Simplicity||Simpler to understand than annualized return.||More complex to understand than the absolute return.|
|Usefulness||It can be used to compare the performance of different investments over different time periods.||It can be used to forecast future returns.|
|Limitations||Does not take into account the risk of an investment.||It can be misleading if the investment period is short.|
Let us assume your initial investment in Fund A and Fund B is Rs. 10,000 each for a 5-year period.
|Year||Fund A Value||Fund A Absolute Return (%)||Fund A Annual Return (%)||Fund B Value||Fund B Absolute Return (%)||Fund B Annual Return (%)|
|Year 1||Rs. 12,000||20%||-||Rs. 11,500||15%||-|
|Year 2||Rs. 14,000||40%||-||Rs. 13,000||30%||-|
|Year 3||Rs. 13,500||35%||-||Rs. 15,500||55%||-|
|Year 4||Rs. 15,500||55%||-||Rs. 16,500||65%||-|
|Year 5||-||-||CAGR= ((Rs. 16000/ Rs. 10000) ^ (1/5)) – 1 = 10.3%||-||-||CAGR= ((Rs. 20000/ Rs. 10000) ^ (1/5)) – 1 = 14.8%|
Therefore, Fund B has a higher Absolute Return and Annual Return (CAGR) compared to Fund A over the five-year period.
The Annual Return (CAGR) provides a more standardized measure of investment performance, allowing for a fairer comparison between the two investment options.
However, it is essential to consider other factors, like your risk appetite, fund charges, expense ratio, and investment objectives, before making your investment decision.
The choice of a better metric depends on what you're looking for. If you're concerned about the overall growth of your investment, then the absolute return is a good metric to use. But if you're interested in how your investment is performing compared to other investments, then the annual return is a better metric to use.
Imagine that you are running a race. Your absolute return is how far you have run, regardless of how long it took you to run that distance. Your annual return is how fast you are running, measured over a one-year period.
So, which is more important? It depends on your goals. If you want to win the race, then you need to focus on your absolute return. But if you want to improve your running speed, then you need to focus on your annual return.
In the world of investing, it is important to use both absolute return and annual return to measure the performance of your investments.
This will give you a complete picture of how your investments are performing and help you make better investment decisions.
Absolute Return and Annual Return (CAGR) are both essential measures of investment performance. While Absolute Return reflects the exact financial outcome of an investment, Annual Return (CAGR) provides a standardized metric for comparing different investments, making it a more useful tool for assessing long-term performance.
Investors should consider both measures to gain a comprehensive understanding of an investment's performance, taking into account factors like risk tolerance and investment objectives before making informed decisions.
Annualized Return (CAGR) = [(1 + Absolute Return)^ (1 / Number of Years)] - 1
If you want to know the actual gains or losses of an investment over a specific time period, Absolute Return is more straightforward and informative.
Annualized Return (CAGR) = [(Final Value / Initial Value)^(1 / Number of Years)] - 1
Past 10 Year annualised returns as on 01-09-2023
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