Return and Risk are the two most important features of any investment product that are considered in almost all investment related activities viz., stock or portfolio selection, asset allocation, restructuring and performance evaluation.
Investment can be considered as a current commitment of Rupees for a time period to derive benefits in future. The future benefits are known as returns. There are many factors that determine the level of the returns.
Generally, investors who sacrifice their current income would like to get compensated for :
- the time or the period of sacrifice
- the expected rate of inflation, and
- the uncertainty associated with the investment.
Returns from any of your investments will vary depending on fluctuations in business cycles, interest rates and individual corporate profits. Thus measuring your Return on Investment (ROI) is extremely important.
How to measure the Return on Investment (ROI)?
There are different methods of calculating Return on Investment (ROI). The most common return on investment (ROI) calculations are :
- Holding Period Return (HPR) or the Total Return
- Compound Annual Growth Rate (CAGR)
- Return adjusted for Taxes
- Inflation Adjusted Return or the Real Rate of Return
Holding Period Return (HPR)
The period during which you own an investment is known as its holding period and the return for that period is known as Holding Period Return (HPR). In other words, this is the total return earned by the investor by holding an investment for a given period.
If you want to calculate the Holding Period Return for an equity investment of Rs.2500 made two years ago which is now worth Rs.3000 and have given you an income of Rs.500 by way of dividend then, the general formula for Holding Period Return (HPR) is:
HPR = (Current Value + Income Received) divided by Initial Value minus one in percentage terms.
So, HPR for our case will be :
[(3000 + 500)/2500] – 1 = 0.40 i.e. an HPR of 40%
Compound Annual Growth Rate (CAGR)
Note that the Holding Period Return of 40% in the above example is for a period of two years. Investors generally prefer to evaluate the returns in annual terms, i.e. Compound Annual Growth Rate (CAGR), so that comparison of alternate investments is possible. How to convert the HPR that we have calculated in annual percentage?
CAGR = Annual HPR = HPR1/n
The 40% return earned by holding the equity for 2 years is equivalent to an annual HPR of (1.40)1/2 = 1.1832 . Thus, the CAGR of the investment is 18.32%.
Return adjusted for Taxes
Investors are required to pay taxes on the income they earned out of investments. Taxation rules differ from country to country and also vary based on the investment asset class. But the fact remains that the returns are to be adjusted for tax liability.
It is essential that you understand not only the salient features of the various investment avenues available but also to balance your portfolio, taking in to account the tax liability arising out of returns earned. (We will cover this topic in detail in subsequent article.)
Inflation Adjusted Return or Real Rate of Return
In calculating return over a number of years, you must consider the stream of income over time. When investment is made, you as an investor postpone your current consumption for future income. If during, the period of investment, the price of goods or services raises, you require more money to acquire the same.
Prices of goods and services rise during the period of inflation. This reduces your purchasing power. It is therefore essential to adjust your total return on investment for inflation. Such inflation adjusted returns are known as Real Rate of Return.
To illustrate, consider the following information:
- Value of an investment in the beginning period is Rs.100000
- Income received during the year:
- Dividends – Rs.8000
- Capital Appreciation – Rs.12000
- Inflation Rate is at 5 %
- Total return on this investment is (8000+12000)/100000 = 20% whereas real rate of return after adjusting for inflation would be 15% (i.e. 20% minus 5%)
Measuring your return on investment is critical to evaluate various investments. It helps in building a better portfolio and take asset allocation decisions. Another factor which is equally important is, understanding and managing risk associated with investment.