Let's step back for a moment and see how we calculated the return for Mr. A. The formula we used was --
{[(Present Value of Investment - Purchase Price)/(Purchase Price)]*100}
={[(2,000,000 - 1,000,000)/(1,000,000)]*100}
={(1,000,000/1,000,000)*100}
=100%
In calculating the return in this manner, we are making one mistake -- we are ignoring the time factor (in this case 11 years). While in absolute terms Mr. A seems to have hit the jackpot, we need to calculate the effective return he has earned over this time period to be sure that he actually has! For this, we need to understand the concept of CAGR i.e. compounded annual growth rate. The CAGR, simply put, is the return an investment generates over a period of time, assuming that earnings in the first year are reinvested and so on and so forth.
The following is the formula for CAGR (now things get a little complicated) --
{(Present Value of Investment /Purchase Price)^[1/(Period of holding)]}
= {(2,000,000/1,000,000)^[1/(11)]}
= 2^(1/11)
= 6.5%
Now, surely, the 'return' looks less exciting -- only 6.5% per annum over 11 years! An investment in the RBI Relief Bond would have fetched a much higher return (about 12% per annum)!
Understanding how to calculate the return in the right manner is very crucial. As we have seen above, the perception can change dramatically if an incorrect measure were to be used.
We now know that Mr. A has earned a return of 6.5% per annum over the last 11 years. We are therefore led to believe that even though Mr. A has not earned as much as he could, he nevertheless has added to his wealth.
And this brings us to another important concept of 'real' return. How do we calculate 'real return'?
= Market Value of Investment - Adjusted cost of investment OR
=(Market Value - Cost of Investment) - Depreciation in value of money (due to inflation)
How do we calculate the depreciation in value of money? The Central Government notifies a Cost Inflation Index that helps get over this. In our case, the Cost Inflation Index for the two years is as follows --
1992 - 199
2003 - 447
This basically means that if you had invested Rs 199 in 1992, the inflated cost of the same is to be treated as Rs 447 in 2003 i.e. Rs 1.00 then is equivalent to Rs 2.25 today!
So what is the adjusted cost of Mr. A's Rs 1,000,000 investment?
= Rs 1,000,000 * 2.25
= Rs 2,250,000
Therefore the real return earned by Mr. A is --
= Rs 2,000,000 - 2,250,000
= Rs (250,000)
i.e. Mr. A has actually destroyed wealth over this 11 year period!
Are your returns real? Find out now!
So what seemed to be a jackpot, turned out to be a wealth destroying move by Mr. A. So the next time you come across absolute numbers, be sure to dig deeper to find our what the actual annual return was, and whether, there is a 'real' return in it or not.
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