The basic objective of investment is to increase the amount of assets. The higher the potential investment return, the better it is, of course. Therefore, the challenge is how to measure investment performance correctly, so that you can understand the true potential return.

Mutual Fund investment is an investment that requires a comprehensive understanding of how return is calculated. There are two types of return metrics in mutual funds: Absolute Return and Compounded Annual Growth Rate (CAGR).

Absolute return only considers the initial investment amount and the final investment amount.

Absolute calculation does not take into account the period or duration of investment during which the return is obtained.

Absolute return is calculated as follows:

Absolute Return (%) = (Final Investment Amount - Initial Investment Amount) / Initial Investment Amount * 100

For example, suppose an investor invested Rp1,000,000.00 in the past and today the investment value is worth Rp1,200,000.00. Then this investment generates an absolute return of 20%.

Absolute Return (%) = (1,200,000–1,000,000) / 1,000,000 * 100 = 20%

An investor can achieve this 20% return in a matter of months or decades. Thus, it is very difficult to make a decision based solely on absolute return, whether an investment is good or not. Absolute return only tells how much the investment value has grown, but does not provide a picture of how quickly they grow.

When evaluating investment instruments and their potential return, both factors—how fast and how much return is generated—are important. Absolute return only accounts for how much return is made without providing information on how quickly the return can be generated.

CAGR is Compound Annual Growth Rate or average annual return

Not only does it take into account how much return is generated, CAGR also takes into account how quickly the return is generated. This is the difference between CAGR and absolute return.

CAGR is calculated as follows:

CAGR (%) = Absolute Return / Investment Period (years)

For example, an investor has two investment options. In the first option, the investor gets an absolute return of 10% over 20 months. In the second option, the investor gets an absolute return of 5% over 10 months. Now, to determine the best option, the investor will calculate the CAGR of both options.

For the first option: CAGR = 10% / 1.67 (derived from 20 months / 12 months equals 1.67 years) = 5.98%

For the second option: 5% / 0.83 (10 months / 12 months equals 0.83 years) = 6.02%

Now, after comparing both options, the investor can see that the second option generates a better return than the first option. Despite the fact that the second option has an absolute return that is only half of the first option's absolute return, the second option is better at generating investment, therefore the second option is more promising.

When choosing to invest in a Mutual Fund, an investor needs to consider the two factors above. Knowing this is quite important because absolute return does not take into account the time period during which the return is received. The investment period is very important to determine whether an investment is good or not. Simply put, it is not just about higher returns, it is about faster and higher returns.

 

Read also:

Why Invest Long-term in Mutual Funds?

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Mutual Funds or P2P Lending – Which to Choose?