To know real returns, look at annual return, inflation

This new year, be aware of these two important money basics. First, the time value of money. This is nothing but the impact of inflation on your money. Understanding the impact of inflation on your money is one of the most important things in investment. Second, is annualised return. Usually when we talk about returns, we say things like, my investment doubled or my property value is now two times what I bought it at. However, by itself this has little meaning unless it is adjusted for the time value and expressed more in terms of annualised return. Here is how you can do it.

Time value of money

Everyone knows about the term inflation. It means the degree by which the cost of a basket of goods and services changes each year. The current (November 2018) CPI inflation at 2.31% means that the price or cost of the said basket of goods and services has increased by 2.31% or ₹ 2.31 for every ₹ 100 as compared to its price in November 2017.

It also means that the value of money fell by that much. Or in other words, your ₹ 100 can now buy things to the value of ₹ 97.69 (100-2.31). Hence, ₹ 100 today is not the same as ₹ 100 a year ago.

Now coming to how this impacts your investment evaluation. If you say that you bought an asset for ₹ 100, five years ago and its worth ₹ 200 today. It straightaway looks like a gain of 100%. However, remember the ₹ 200 should be adjusted for inflation in each of the five years to ascertain its true value before you realise the gain.

Now, this calculation while it is valuable in understanding that the time value of money is usually depleting, it is hardly ever used to show case returns. This is because other than in tax calculation, there is no practical purpose.

What you should keep in mind is that in order to earn real positive returns, you need to invest in assets that are able to beat annual inflation, its only when this happens will you truly grow your money.

Absolute versus annualised return

Doubling of money is gain expressed in absolute terms. Now if your money doubles in a year, you make 100% return annually. If it doubles in two years, your annual return is 41.5%. If it doubles in three years, your annual return is 26% and if it doubles in six years, your annual return is 12.2%.

You cannot compare the efficiency of two sets of asset returns without accounting for their annualised return. Now let’s say your property investment doubled in three years and your equity investment doubled in two years. While selling both these investments you will only remember that they doubled and think that both have performed similarly. In reality, return from equity investment is better as money doubled in lesser time.

Don’t just perceive the return for its face value, always try to analyse the real return especially when comparing between two sets of asset returns.