Understanding Annualized Returns vs. Yearly Returns in Mutual Funds

Investors often focus on the quantum of returns earned from their mutual fund investments. However, the time horizon is equally important in determining the true performance of an investment. In this article, we explore the differences between annualized returns and yearly returns in mutual funds and why it’s crucial to understand both.

Introduction to Returns

Imagine you invested Rs. 1 lakh in a mutual fund scheme. Over a period, you earned a return of Rs. 50,000, bringing your total to Rs. 1.5 lakh. While this might sound like a significant amount, the speed at which you earned this profit can significantly impact your overall satisfaction. Let’s consider two scenarios—earning this profit in one year versus earning it over ten years.

Yearly Returns vs. Annualized Returns

Yearly Returns solely reflect the performance of your investment within a single year. They can be a misleading measure when assessing the long-term performance of your investment, especially if the investment period is short.

Annualized Returns, also known as CAGR (Compounded Annual Growth Rate), provide a more holistic view by calculating the average annualized growth rate over a specific period. CAGR takes into account the compounding effect of returns, which means it considers both earnings on the principal amount and any reinvested profits. This makes it a more accurate representation of the true performance of your investment over time.

The Importance of CAGR in Mutual Funds

In mutual funds, returns are often reinvested. As a result, the performance of your investment grows on a compounded basis. This is where CAGR comes into play. CAGR helps you understand the average annual growth of your investment over a specific period, which is crucial for long-term investment planning.

For instance, if you have been investing in a mutual fund scheme for 10 years and the CAGR of your investment is 10%, it means that over this period, your investment has grown at a rate of 10% per year on average, considering the compounding effect. This provides a more realistic and accurate picture of your investment’s performance.

Comparing Different Schemes

When comparing different mutual fund schemes, it’s important to consider both absolute returns and annualized returns. Let’s illustrate this with an example:

Example 1: Scheme A

Assume Scheme A delivered an absolute return of 45% in 3 years. An investment of Rs. 1 lakh grew to Rs. 1.45 lakh.

Example 2: Scheme B

Meanwhile, Scheme B gave an absolute return of 38% in 2 years. An investment amount of Rs. 1 lakh grew to Rs. 1.38 lakh.

When you look at absolute returns alone, Scheme A appears to be a better investment. However, when we calculate the CAGR, we see a different picture:

**Scheme A’s CAGR**: Approximately 13.2% per year **Scheme B’s CAGR**: Approximately 17.5% per year

These numbers reveal that Scheme B is actually outperforming Scheme A in terms of the average annual growth rate. CAGR provides a clearer and more accurate comparison between the two schemes, especially when the investment periods are different.

Conclusion

In summary, while absolute returns indicate the total gain on your investment, CAGR (annualized returns) offers a more comprehensive understanding of your investment’s performance over time. It accounts for the compounding effect and enables you to make more informed decisions when evaluating mutual fund schemes.

We hope this helps you make better-informed investment choices.

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