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Tuesday, October 28, 2008

How to Measure Returns

Azizi Ali, one of our famous local millionaires not only accumulates wealth for himself, but also help others achieve the same by training and imparting his knowledge. I found this topic quite interesting as I get questions or statements from friends and family members who say that market is down, so don't invest! or I'd want to monitor my fund performances on my own (mutual funds, to be exact) so that I know how much returns I'm making..

Special Report: How to Measure Returns
by Azizi Ali

"I made fifty thousand in the stock market in 99!" an acquaintance proudly declare. In fact, it was so loud, he was practically screaming in your ear. Which kind of make you feel inadequate because you only made ten grand. So you quickly change the conversation subject to the mating rituals of extinct Sagittarian Mongolian bisons.

But hold on a second. Though it's true that you made less money than him, it does not necessarily mean that he is one up on you. Because we are only talking of straight figures so far. And that is not how return on investment are calculated.

The correct way of measuring returns is in two ways: in percentage form and on an annual basis.

Return must be expressed on a percentage term

Return expressed in straight ringgit/dollar/yen has little meaning. This is because straight ringgit amount do not reveal the amount of money that had to be invested in order to earn that return.

For example, is RM10,000 a good return? The answer is that it depends on the amount invested. If RM50,000 was invested, then RM10,000 would be an excellent return as it is a 20% return. However, if the original investment was RM500,000, then the return is a measly 2%. If his layout was five million instead, then he would have cried as his return is...0.2%! Pass the tissue paper, please.

Return must be expressed on an annual basis

But the job doesn't end there. Even after expressing the return in percentages, it must also be expressed on an annual basis. This is the universally accepted way of stating a percentage return.

Following the earlier example; if the RM10,000 return from the RM50,000 was realized after just 6 months, then the annual return is 44% (The return is 44% instead of 40% due to the compound effect). And even if the investment was cashed out after that six months, we would still consider the return as 44%.
If on the other hand, the RM10,000 was realized at the end of two years, then the return is only 9.54%. (Again, the 9.54% return instead of 10% is due to the compounding factor).

So now you know that the return of x % in y number of years - often quoted by fund managers - is not the right way of indicating return on investment. A 50% return in five years may look good but that is only 8.44% annual return.

Then we can compare

Once we have the returns expressed in percentage form and on an annual basis, only then we can compare the various returns from different investments. Only then the comparison be fair and sensible. Orange to orange, durian to durian.

Coming back to the beginning example, if the guy made RM50,000 from investing RM500,000, his return on investment is 10%. Not bad. Something to crow about, I suppose.

But since you made the ten grand by investing only RM20,000, your return is a fabulous 50%! Whaddaya know - You are the winner!

Now you can go back talking about sex and dead Sagittarian Mongolian bisons.

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