How to Measure Returns: Beyond the Numbers

In Short

• Measuring investment returns properly is crucial to evaluating financial progress, yet many investors make basic mistakes that lead to poor decisions

• There's a significant difference between absolute, annualized, and real returns – knowing which to use and when can completely change your investment strategy

• Risk-adjusted metrics like Sharpe and Sortino ratios reveal the true quality of your returns, not just the quantity

• Comparing your investments against appropriate benchmarks helps distinguish between skill and luck

• After accounting for inflation and taxes, many seemingly impressive returns become merely adequate or even disappointing

AI generate image to showcase a person measuring financial returns in a wrong way

If I had ₹100 for every time someone told me about their "amazing" stock market win without understanding how to properly measure returns, I could retire tomorrow. We've all heard it at family gatherings—"I made 20% on that stock!" But when pressed for details: "Well, I bought it at ₹1000 and sold it at ₹1200." The inevitable follow-up question that makes everyone uncomfortable: "Over what time period?"

Measuring investment returns is like measuring your health. Looking at just your weight without considering other factors (muscle mass, blood pressure, cholesterol) gives an incomplete—sometimes dangerously misleading—picture. Similarly, a simple percentage gain or loss doesn't tell you enough about your financial health.

As the legendary investor Warren Buffett famously said, "Price is what you pay, value is what you get." I'd add: "Return is what you calculate, progress is what you make."

Let's start by clearing up a fundamental distinction. Absolute returns simply tell you how much your investment grew overall, while relative returns measure performance compared to a benchmark or adjusted for time. Your friend bragging about making ₹20,000 in the stock market is sharing an absolute number with zero context. Without knowing how much was invested and for how long, this information is virtually meaningless.

Key Metrics to Measure Investment Returns

1. Absolute Return

Think of absolute return as the most basic measurement—like using a bathroom scale. It simply shows the percentage change between your starting and ending investment values.

Absolute Return = (Final Value - Initial Value) / Initial Value × 100%

If you invested ₹1,00,000 and now have ₹1,50,000, your absolute return is 50%. Simple enough. But this metric doesn't tell you how long it took to achieve this return, which is crucial.

I remember a friend boasting at a family dinner about her 40% return on a fixed deposit. Impressive, right? Until we discovered she had held it for 5 years. That's not 40% annually—it's about 7% per year. Context matters.

2. Annualized Return (CAGR – Compound Annual Growth Rate)

Enter CAGR, which evens the playing field by converting returns into an annual rate, regardless of the time period.

CAGR = (Final Value / Initial Value)^(1/n) - 1

Where 'n' is the number of years.

Using my friend's example: CAGR = (₹1,40,000 / ₹1,00,000)^(1/5) - 1 = 6.96%

Suddenly, her investment looks much more ordinary.

As renowned economist Burton Malkiel put it, "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time the market, they should try to be fearful when others are greedy and greedy only when others are fearful."

3. XIRR (Extended Internal Rate of Return)

Real life is messy. We rarely make a single investment and leave it untouched. We add money during market dips, withdraw during emergencies, or invest monthly through SIPs. This is where XIRR becomes invaluable.

XIRR calculates returns when cash flows occur at irregular intervals. It's like having a sophisticated fitness tracker instead of just a scale—it accounts for all the variables.

Most spreadsheet programs have an XIRR function, where you input dates and corresponding cash flows (negative for investments, positive for withdrawals), along with the current value as a positive cash flow on the current date.

This link will help you to use XIRR in Microsoft excel.

I use XIRR religiously for my SIPs. Last year, what looked like a mediocre 8% absolute return on my mutual fund SIP was actually a respectable 12.3% XIRR, because I had been investing consistently through market highs and lows.

Accounting for Inflation & Taxation

1. Real vs. Nominal Returns

Imagine celebrating a 7% return on your investment, only to discover inflation was 6% that year. Congratulations—your money grew by just 1% in terms of actual purchasing power!

Real Return = ((1 + Nominal Return) / (1 + Inflation Rate)) - 1

This calculation is humbling for most Indian investors. Our high inflation environment means those double-digit returns often shrink dramatically when adjusted for reality.

As I tell readers on my blog: "Nominal returns feed your ego; real returns feed your future."

2. Post-Tax Returns

Then comes the government's share. Different investment vehicles in India have varying tax implications:

• Equity investments held for more than a year: 10% LTCG tax on gains above ₹1 lakh

• Debt funds: 20% LTCG with indexation benefit (if held for over 3 years)

• FDs: Taxed at your income slab rate

A seemingly impressive 12% pre-tax return on an FD for someone in the 30% tax bracket becomes just 8.4% post-tax. Meanwhile, a slightly lower 11% from an equity fund held long-term might result in 10.5% post-tax return for gains under ₹1 lakh.

As Benjamin Graham wisely noted, "The investor's chief problem—and even his worst enemy—is likely to be himself." I'd add that his second-worst enemy is probably the tax department!

For Advanced Readers - Risk-Adjusted Return Metrics

Risk-adjusted return measures how much investment return you're receiving in relation to the amount of risk you're taking on—essentially revealing whether you're being adequately compensated for the risk you're enduring. Think of it as the difference between two mountain climbers who both reached the same height, but one took a treacherous path while the other used a safer route.

1. Sharpe Ratio

Higher returns almost always come with higher risks. The Sharpe ratio helps you determine if the additional risk is worth it:

Sharpe Ratio = (Investment Return - Risk-free Return) / Standard Deviation of Investment Returns

A higher Sharpe ratio indicates better risk-adjusted returns. Generally, a Sharpe ratio above 1 is considered acceptable, above 2 is good, and above 3 is excellent.

2. Sortino Ratio

The Sharpe ratio penalizes both upside and downside volatility. But as investors, we only dislike downside volatility! The Sortino ratio improves on this by focusing only on downside risk:

Sortino Ratio = (Investment Return - Risk-free Return) / Downside Deviation

I prefer using the Sortino ratio when analyzing aggressive equity funds. After all, I've never heard an investor complain that their returns were higher than expected!

3. Standard Deviation & Beta

Standard deviation measures the volatility of returns. A high standard deviation means wild swings in value—potentially great in bull markets but terrifying during bears.

Beta measures an investment's volatility compared to the market. A beta of 1 means it moves in line with the market. Above 1 means more volatile, below 1 means less.

My mother once proudly showed me her investment in a "stable" large-cap fund, puzzled why it fell so dramatically during a market correction. One look at its beta of 1.4 explained everything—it was actually 40% more volatile than the market.

Comparing Investment Returns with Benchmarks

Imagine running a race and celebrating your finish time without knowing how far you ran or how fast others completed the same course. That's essentially what happens when investors evaluate returns without benchmarks.

Every investment should be measured against an appropriate yardstick:

• Large-cap funds against the Nifty 50 or Sensex

• Mid-cap funds against the Nifty Midcap 100

• Small-cap funds against the Nifty Smallcap 100

• Debt funds against similar maturity government securities

If your actively managed large-cap fund returned 12% while the Nifty 50 returned 13%, you're actually underperforming despite the seemingly good absolute return.

Measuring returns properly isn't just about mathematical accuracy—it's about honesty with yourself. It's easy to celebrate the winners and forget the losers, to remember the peaks but ignore the valleys.

True financial progress comes from understanding not just how much you made, but how you made it, over what time period, compared to what alternatives, adjusted for inflation and taxes, and with what level of risk.

As Peter Lynch wisely said, "Know what you own, and know why you own it." I'd add: "And know exactly how well it's really performing."

The next time someone boasts about their investment prowess at a dinner party, ask them about their CAGR, their real returns, their Sharpe ratio, and their benchmark comparison. The sudden silence might be deafening, but the lesson will be invaluable.

After all, in the world of investing, what you don't measure, you can't improve.