Friday, January 16, 2009

Measuring Investment Returns !

The returns are of two types Realized return is what is ex post or after the fact return. Realized has occurred and it is the fact and measure of accurate data. Estimated return is what we hope or expect to gain, this return is subject to uncertainty and may or may not occur.

Historical returns of any product plays a large part in estimating future returns.

Returns of an Investment has two components.
1) Yield: This is periodic cash flow from any investments like interest or dividend. most FDs have interest generated yearly, or quarterly. and Stocks , Mutual funds declared dividends from time to time. Yield is the measure of cash flow to the price of a security.

2) Capital Gain (loss) : The second component is the capital appreciation(or depreciation) in the price of an asset, price of a stock.

Total return = Yield + Price Change(capital gain)

Current yeild
It is simple measure of returns on any security and is = annual interest/price of security.

Yeild to Maturity(YTM)
Returns of bonds most often quoted for investors is Yield to Maturity (YTM), It is defined as promised compounded rate of return an investor will receive from bond purchased at market rate and hold till maturity.

computation of YTM
P = C/(1+r) + C/square(1+r) + C/ntime(1+r) + M/ntime(1+r)

P= price of security
C=annual interest
r= rate of interest
M=Maturity value
n=number of years

Compounding vs Discounting
The concept of compounding, that is interest on interest is an important concept.

Post Tax Returns (Tax Adjusted Returns)
As an investor you should learn that taxes can eat up lot of your returns so what is more important is what you keep rather then what you make.

example: if you make 50% in a product 'A' , out of which 30% will go for tax payment so you have left is just 20%
If you have product 'B' which gives just 30% returns with tax being nil on it because it is tax free. so the final returns you gain is net 30% from product B.
So Definately even though product A gives more returns but for investor product B is better option.

Real Return(Inflation Adjusted return)
All the returns we calculate are Rupee returns. It does not actually talk about purchasing power of these rupees. In 1950 you could see movie for less then Rs 1 now even if your 1 rupee has grown 50 times you will still be not able to see the movie today as it cost over Rs 100.
so the inflation has killed your purchasing power instead of your wealth being increase if you look at inflation adjusted returns it has actually diminished.

Real return = { (1+ Nominal Return) / (1+ Inflation rate) } - 1
Note: merely subtracting inflation rate from the nominal return will get less accurate result.

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