Sometimes you might get confused in choosing among various similar investment options. Well, of course, only when you try to find out what's best as per your goals instead of relying on your colleague's unsolicited advise. Marketing guys have phrased several fancy lines like "doubling your money in x years", " 3 times your money in y years", "Getting your capital back in just z years" . Such lines might be presented just to sell you the schemes, hiding their fundamental details. Because, at the fundamental level, their products may not be different.
The fundamental measure of investment performance - Compounded Annual Return
Only alike investment options can be compared here. For example, comparing a fixed deposit with another fixed deposit, comparing an insurance with another insurance or comparing an equity oriented mutual fund with another such mutual fund. We are calling comparables as "Investment Apples". Now, an apple might promise you to give 10% Return on Investment (ROI) annually, another might say that they will double your money in 8 years. 100,000 invested at 10% expected ROI will become 214,359 at the end of 8 years, which is more than double! Therefore, scheme promising 10% ROI for 8 years is better than the scheme providing double the money in 8 years. Comparing the actual amount you get was one way of analyzing this. The more standard way is to observe, how much % do you gain on your investment per year? The investment option giving you more % return annually is better than the other. In our example, the scheme of doubling the money returns a little more than 9% per year. Hence, 10% per year is better than that. If somebody promises you to return double the investment amount in 10 years, that is not something to get excited about. Measure it's average annual return, you might just get surprised. Try measuring the average annual return for different schemes using our Financial Calculator.
Mathematics of Annualized return (only for nerds)
Suppose you invest Rs. 1000 today at 8% per annum compounded annually.
=> After one year, you will have 1000 + 8% of 1000 = 1080 = 1000x(1+8%)^1
=> After two years, you will have = 1080 + 8% of 1080 = 1166.4 = 1000x(1+8%)^2
=> After n years, you will have = 1000x(1+8%)^n.. and so on
Now, suppose you knew only 1166.4 as the maturity amount which you were supposed to get after 2 years, and 1000 as your investment amount. Here, when you wanted to calculate your annualized return,
We could write the above formula as: 1000x(1+r)^2 = 1166.4, where r is your annualized return Rearranging the equation, we get r = (1164.4/1000)^(1/2) - 1 (we told you, it's for nerds). This way we can get the annualized return. In general, it can be calculated as:
(Maturity amount/Investment amount)^(1/no. of years) - 1
Annualized return is simply the average return earned per year, and widely used as Return on Investment or ROI.
Caution: Don't compare oranges with apples using this technique
Comparing investment options on basis of their annualized return is valid only when you compare similar options. Precisely, the schemes having same risk and nearly same investment period. Investment period is straight forward, but how do you go about measuring risk? Well, risk is something complex. Nevertheless, you can still assume the risks of various categories of investment to be same. For example, you may compare fixed deposit schemes of two different banks using this, you may compare debt oriented mutual fund scheme of two different funds. But, you should not compare a fixed deposit scheme with a mutual fund using only annualized returns!
Is that all about comparing apples?
No, this is not all, but this is the root. In further posts, we will be looking at comparing some complex apples. You don't usually invest a lump sum amount, rather you invest regularly, right? We will be analyzing the performance of such regular investments in coming posts. Till then, post your queries below in comments. We would be happy to take them up :)