Mr. Mehta : XYZ is a fantastic fund. It has given me 21% returns p.a.
Mr. Khanna : What are you saying ? I have the same fund, but it has given me only 5% returns. Bank Recurring Deposit (RD) would have been better.
Mehta : How long have you been invested in it ?
Khanna : I invested in it 5 months back.
Mehta : So 5% in 5 months is almost 12% annualised Dude.
Khanna : What is the meaning of annualised return ?
Mehta : For example, you have 2 products A and B. A gives you 8% return in 6 months and B gives 10% returns in 12 months. Which is better ?
Khanna : Obviously A.
Mehta : Why so ?
Khanna : Because if A has given 8% return in 6 months , after 12 months the return would be around 16%.
Mehta : Great. So basically what you have done is standardized the return period to 12 months for both the products, so that you can compare. This is what we call annualised return.
Khanna : Wow. Thanks. Now I understand it better. 12% looks good. But it is still less than 21% as you say. Whats that about.
Mehta : Have you done a lumpsum investment or doing a monthly SIP ?
Khanna : I am investing some amount every month since last 5 months ?
Mehta : So that makes your average holding period only 2.5 Months.
Khanna (Confused) : Whats this “Average Holding Period” now ?
Mehta : When you started your SIP 5 months back, your first instalment got 5 months time to grow, your second instalment got 4 months and so on. Your last instalment is not even a month old now.
Khanna : Correct.
Mehta : So if you take an average, your total investment has an approximate holding period of 2.5 Months. Now, when you annualise it, it becomes almost 24% p.a.
Khanna : Wow, Finally I have beaten you.
Mehta (Smiling ) : See this is the problem. Before some time, the fund was bad as your returns were “appearing” to be lower than mine. Now, that your returns are proved to be higher than mine, then the fund is not great. Its you who have beaten me.
Khanna : I was just kidding.
Mehta : I know. My Point was, we say that we want to know the truth. But we don’t really take some efforts to understand the truth. We take things the way they are presented to us. This is where your truth becomes different than my truth.
Khanna : But truth is still a truth right.
Mehta : This is like a half glass water story. You say its half full, I say its half empty. Whats the truth ? Both are truth. Its how we look at it. In this example, we had same fund but still the different perception about returns gave us different opinion about it. There could be cases, wherein 2 people invest in same fund but with different mindset and profile, may get different returns. It is very person specific.
Khanna : One last question. How do you really calculate all this average holding period, annualised returns etc when your portfolio grows large ? Its difficult, time consuming and cant be sure of being correct.
Mehta : My Financial Advisor does it for me. And now I have even stopped bothering too much about the annualised returns also. I know in short term it can fluctuate. But in the long term, if it helps me achieve my goals, how does the short term fluctuations matter ?
We look forward to your valuable comments and feedback.
The Author Prof. Saurabh Bajaj (BE, MBA, FRM, CFGP) is CEO with Nidhi Investments, Mumbai. He may be contacted on CEO@nidhiinvestments.com if you have any questions.
(The views mentioned in the article are personal opinion of the author)