Understanding Return
Calculating return would have been easier, if we
had been investing exactly for one year. But that doesn’t happen in practical
world. Investment is normally done in staggered manner and each investment is
not kept for same period of time. Withdrawal also might happen over a period of
time.
To compare the return from various investment
plans, it is necessary to have a common parameter which can be used for all
types of investments with different investment amounts and different holding
period. That common parameter is to assume that all investment returns get
compounded annually.
If investment is held for lesser than one
year, then we need to calculate the return in percentage terms by assuming that
the investment is held for one year.
CAGR – Compounded Annual Growth Rate
If you want to calculate the return for one time
investment then CAGR (Compounded Annual Growth Rate) is used.
But when the investment is done periodically or staggered over a period
of time, CAGR is not useful to calculate the return.
In case of staggered investment, either IRR
or XIRR can be used.
IRR – Internal Rate of Return
If the investment is done in strict periodic
manner, you may use IRR to find out the rate of return. For example if
investment is done at fix interval (Monthly/quarterly/yearly) and
withdrawal only at the end of the entire tenure, IRR can be used to find out
the return.
XIRR
If cashflow includes frequent inflow as well as
outflow over a period of time, we need to use XIRR for calculating the rate of
return. XIRR gives you the flexibility to assign specific dates for each
cash flow, making it a much more accurate calculation.
Though Return is one of the most important criteria
but we should also look at other parameters like consistency, portfolio
quality, risk, risk adjusted returns etc.
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