Management guru Peter Drucker, who believed that the lack of sufficient quantifiable data will impede processes and systems, once said - “You can’t manage what you can’t measure”.
As anyone who has kept an eye on the nation’s investment space would know, a great many things have changed in the past decade. Newer regulations have replaced the older set, sharper practices have bypassed archaic strategies. Financial planning has never been more nuanced, the average investor has never been more intrepid, inflows have never been more robust, and the product basket has never been wider. Yet, and yet, there are still a great number of questions regarding simple, fundamental matters. Take, for instance, the subject of returns.
In all fairness, investors are not really interested in the manner in which returns are calculated and dished out on a platter. “How do you measure returns?” – that is not a very popular question.
What people are usually quite keen to know relates to the numbers they have clocked, that is, the performance that their portfolios have actually achieved. “How much are my returns?” – that poser keeps us on tenterhooks for days on end. And not without reason; we are all driven by fear and greed, after all.
I write this piece today to enunciate the obvious: without a clear comprehension of returns, our decisions with regard to allocations will be flawed.
All investors must, therefore, have a clear understanding of how much, and in what manner, their wealth has grown.
To be more specific, it is critical to obtain at least a rudimentary knowledge of returns. We don’t need to possess Einstein’s brains to do this. Believe it or not, mid-schoolers who attend arithmetic classes can understand elementary gains-and-losses calculations. Here is an attempt to explain a few important basics.
Simple returns
This is the most popular (but not the most flawless) measurement chased by most investors. The total increase or decrease in an investment (read: in its valuation) is a major consideration at all levels. An investment of ₹100 in a financial asset may have grown to ₹130. That translates to 30 per cent returns. As easy as pie.
Compounded returns
Imagine a situation when valuation gains are reinvested. Thus, returns must be worked out on the basis of the original investment as well as the accumulated profits. Compounding -- as the adage goes, it is the eighth wonder of the world -- works perfectly well for patient investors. Astute players wish to gain exponentially in this manner. In short, “I will earn returns on my returns” is a compelling logic for most of us.
Compounded annual growth
CAGR (Compounded Annual Growth Rate) is a trusted yardstick in investment circles around the world. It is used as a standardised tool to compare valuation growth of various assets.
Here is how the calculations are stacked up. Let us assume you have invested ₹10,000 in a stock, and you intend to hold it for a few years. Let us also assume that the market is choppy, there are frequent ups and downs.
- First year: The stock goes up by 10 per cent, and your valuation increases to ₹11,000
- Second year: The market advances handsomely and your stock returns 20 per cent. So your valuation stands at ₹13,200 (11,000 + 20 per cent of 11,000)
- Third year: The market slows down, positions are getting liquidated. The stock returns -5 per cent (negative). And your valuation declines to ₹12,540 (13,200-5 per cent of 13,200)
The lay investor will now grapple with an interesting question — considering all the numbers scored across three years, what are his returns? Check out these points:
Simple returns: [(12,540 - 10,000) ÷ 10,000]x100 = 25.4 per cent
CAGR: [(12,540 ÷ 10,000) ^ (1/3)]-1 = 7.97 per cent
The second tally will naturally appear more realistic. It is certainly very relevant because the period of holding is way longer than a year. CAGR presents an accurate picture, and professional circles encourage investors to ascertain returns on the basis of CAGR. This metric is in fact a universally accepted tool for mapping performance.
I hope all investors will use it in their normal calculations, especially when comparing two similar investments. Performance delivered by stocks, bonds or any other financial asset can be evaluated in this manner. CAGR gives us a neat window through which historical returns can be viewed.
Last, a serious point in straight words. Returns are calculated and delivered to us by all sorts of information providers. Intermediaries do it all the time, and their clients are given ready-to-use data. Much of this is based on historical developments. The average investor makes use of statistical evidence to take his next step, to time his next allocation, to execute his next buy or sell.
The writer is director of Wishlist Capital