You can’t eat CAGR or XIRR

Amit is a smart investor and has earned an XIRR of 20% on his investment made 15 years back.

Roshan is a conservative investor and invested Rs 50 lacs in a residential property 15 years back. The value of his investment has now grown to Rs 2 crores. He is extremely proud of this investment decision.

Then, he joined Twitter. He is told, 4X over 15 years is just a return of 9.7% p.a. And then comes the knockout punch, “If he had invested this in stock markets, his investment would have grown to say 4 crores. Roshan goes on the backfoot and wonders if he made the wrong choice.

No, he did not make a wrong choice.

Such social media warriors may have knowledge of a 70-year-old but show wisdom and judgement of a 7-year-old. Their focus is just on the Returns (XIRR, CAGR). However, you cannot eat XIRR. Eventually, all that matters is the absolute return.

And Roshan did well on that front.

Yes, he could have done better by investing those 50 lacs in stock markets 15 years ago. But that’s just hindsight bias. It ignores many important aspects.

Investing is not just about start and end points. The journey also matters. If the experience is too bad, you may quit in between.

What if there was a good chance that Roshan would not be able to digest market ups and downs and quit at a wrong time? Of course, we don’t know that about Roshan. But Roshan does.

If he thinks that stock markets are too volatile for him. And that real estate always gives good returns over the long term (this may be a misplaced conviction but is conviction nonetheless), he is perfectly rational and justified in doing what he did.

Read: How do you calculate Mutual fund returns? CAGR, IRR or XIRR?

The Amount invested also matters

Going back to Amit and Roshan, who did better?

Since Amit earned better returns, he is the winner here.

Is it? Or are we missing something?

A = P * (1+R) ^ n

A is the current value of investment. P is the amount originally invested. R is the rate of return earned. And “n” is the time lapsed.

Usually, our focus is on “R” and “n”.

We speak about earn good returns over the long term. That’s “R” and “n” for you.

What about “P”, the amount invested?

Does “P” not matter?

It does.

Rs 1 lac over 15 years at 20% p.a. grows to Rs 15.4 lacs. Tremendous. 15X growth. An absolute gain of Rs 14.4 lacs

Rs 50 lacs over 15 years at 9.7% p.a. grows to Rs 2 crores. An absolute gain of Rs 1.5 crores.

In absolute gains, Roshan beats Amit hands down.

What do you need to increase “P”?

The most important part is conviction.

Unless you have the conviction, you won’t be able to invest meaningful amounts. And we have seen above that the size of the bet matters too.

Roshan had conviction in real estate investments. The conviction that he will not go wrong with that choice. Please note conviction can be misplaced, which can be a problem. Whether right or wrong, you need conviction to make those big bets.

And how do you build conviction?

The conviction can come from experience, knowledge or even beliefs.

Hence, he invested Rs 50 lacs at one go. He was NOT bothered by ups and downs in the market value of the investment. In fact, he did not bother to check.

You may argue we are comparing apples and oranges. Rs 1 lac from Amit and Rs 50 lacs from Roshan.

You might say, “If Amit had Rs 50 lacs, he would have done much better.”

Perhaps yes, but would he have the courage to invest Rs 50 lacs at one go in stock markets? OR would he be able to stick with the investment during market downturns? Amit may well have the skill, patience, and discipline to succeed in stock markets. However, that’s meaningless because we are analyzing Roshan’s decision here.

Investment success requires you to play to your strengths and avoid the weaknesses. Roshan did exactly that. He was comfortable with real estate and uncomfortable with stocks. What may look like a suboptimal decision to others turned out well for him. And that’s all that matters.

I am not vouching for residential or commercial real estate as an investment. Real estate has its own set of problems. And serious ones at that. I do not like real estate as an investment. But that’s my preference based on my conviction. You may have a different belief system and that will affect your investment choices.

And the conviction bit is not just limited to real estate investment decisions. For instance, I am more comfortable keeping my equity portfolio in a couple of index funds compared to a portfolio made up of 4-5 stocks. While a concentrated portfolio offers you huge upside, it is also a double-edged sword. A diversified portfolio of index funds helps me sleep peacefully at night. I know (or I have the confidence) that I will do well if I hold the same index funds for 10-15 years. And this helps me add to my positions every month. I do not have to worry about tracking performance of the individual stocks in my portfolio.

Without conviction, you will never make meaningful bets. For instance, if you are too scared of equity markets, you would run SIP of only say 5,000 per month despite your monthly savings being Rs 2 lacs. While this technically ticks the checkbox of equity investments, this would never make a meaningful difference to your finances. And what are you missing? Conviction.

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This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.