What returns am I making on my investments?
I get this question every time when someone invests in a (mutual) fund. So let’s try to understand what the fund returns are all about and how to make sure you get to a number which is understandable and gives the real picture of your portfolio return.
Absolute Return: This is the most basic form of understanding your returns on the investment without incorporating any other variable (eg. time, money or weight etc.). To put it simply if you put in Rs. 100 and on the day of measurement the value has become Rs. 101. You have made an absolute return of 1% in that period (could be days or years)
Annualized Return: This is most widely used return metric. The concept is simple you try to annualized returns which were earned in the measurement period. So if the above absolute return was earned in a month the annualized return becomes approx. 12%. Why approx. because the real formula for it would be ((Return+1)^12)-1. Now here you will get 12.68% which also accounts for compounding (those tiny returns over returns on 1%)
IRR or Internal Rate of Return: Now this is a bit of attention seeking. In theory, this return metric is borrowed from capital budgeting which states that…… (we are not here to discuss all that). Basic funda is that it calculates the amount of return generated using the amount of money which gets deployed for that measurement period. Now say, I put in Rs. 100 and then Rs. 10 after 1 year and Rs. 10 after 2 years. The total amount deployed becomes (100+10+10=120). Now after 4 years we see that the final portfolio value is Rs. 150, then we have an absolute return of 25% ((150-120)/120). But to calculate IRR, we need to see that Rs. 100 grew for 4 years, Rs. 10 grew for 3 and 2 years respectively. Hence, the contribution of Rs. 10 which was should be less for two reasons. Firstly, it was only Rs. 10 which is 1/10th of Rs. 100. Secondly, the duration for which it was working for you was only 2 and 3 years. So our return from the calculation was 6.11% click here to calculate.
Note: The concept behind IRR and XIRR is the same, the only difference is the IRR doesn’t distinguish between years and months or days. It considers everything to be one measurement period. So for realistic measurements and distinguishing between time period we use XIRR. Now, this is where the entire story goes out of the window for us to understand the difference. XIRR compounds daily return in a yearly format i.e. 0.5% returns on a fund in 1 days is approximately (250*1%=250%) for a year.
So, in short, go for XIRR/IRR when the period of measurement is more than one year and go for absolute return if it is less than one year.