We have been receiving a number of queries from readers who have problems understanding the rate of return.

Over here we have put down two mails, which are broadly indicative of the queries.

Rule 1: Returns are always given on an annual basis

Many nationalised banks are offering term deposits for Rs 5,00,000 and above at high rates of interest. For instance, a seven day to three month deposit will get you around 4% to 4.5% (short durations).

If I invest in a 14-day duration deposit, I would get more than Rs 20,000 as interest. Within a year, I could make around Rs 1,00,000. Why don't you promote such investments?

Here, the reader has made a glaring error. The returns shown are not monthly returns. Neither are they returns for seven days. They are annual returns.

That means, if she invests Rs 5,00,000 at 4% per annum, she will be entitled to Rs 20,000 per annum. That will be only Rs 1,666 per month (Rs 20,000 / 12 months). 

Now, if we take it for a 14-day deposit, it will boil down to Rs 767 (Rs 5,00,000 x 4% x 4/365).

Similarly, let's say you are being offered 5% on a two-year deposit of Rs 5,00,000. That means you get 5% per annum.

You will earn an interest of Rs 25,000 at the end of the first year.

At the end of the second year, you will get interest on Rs 5,25,000 (Rs 5,00,000 + Rs 25,000). So the interest for the second year will be Rs 26,250.

On maturity after two years, you will land up with Rs 5,51,250.

Calculation = Rs 5,00,000 (principal) + 25,000 (interest for the first year) + 26,250 (interest for the second year)

Rule 2: Check if returns are annualised or absolute

I have often read the returns from mutual funds but don't understand for how long? So let's say I read a figure like 25%. Does this mean if I buy it when it was launched and sell it now, this is the return I would get? Or does it always refer to one year?

Normally, when a fund (or any investment for that matter) declares a return, you will have to ask two questions:

1. What is the time period?

So the fund may declare a return of 25% for one year or for three years or for five years. You will first have to check that out. When you find out how many years it is referring to, you will have to ask the next question.

2. Is the return annualised or absolute?

Let's say that Fund A declares an annualised three-year return of 25% on May 1, 2006.

This is the average annual return. It indicates the return gained (on an average) each year.

So the NAV of May 1, 2003, will be taken and the NAV three years later (May 1, 2006) and the return calculated and then averaged out over the three years.

So the cumulative return has been taken (over three years) and then calculated to give the average annual return.

So you may even find that the annualised return of Fund A for a three-year period was 25%. But the annualised return of the same fund for a 10-year period was only 10%.

That means that the results for the last three years have been quite different from the earlier years. This could mean that the stock market boom has helped push the returns higher. It could also mean the fund has invested in good stocks or the fund manager has changed or is doing a better job.

Let's say Fund A declares an absolute three-year return of 25% on May 1, 2006.

This return will not take into account how much you will get every year. What it means is that if you invested in January 1, 2003, and sold on January 1, 2006, you would have got 25% over your investment (not 25% every year).

Making sense of the figures

Let's take HDFC [Get Quote] Long Term Advantage Fund.

As on May 5, 2006, the returns, as stated by mutual fund research outfit Value Research, are:

One-year return: 78.88% (absolute)

If you had invested just one year ago, you would have got a return of 78.88% for this year.

Three-year return: 83.37% (annualised)

If you had invested in the fund three years ago, the return would amount to 83.37% every year for the past three years.

Five-year return: 57.36% (annualised)

If you had invested in the fund five years ago, you would have got 57.36% every year for the past five years. 

Return since launch: 50.81% (annualised)

Since the fund was launched in December 2000, 50.81% is the return you would have got every year (December 2001, 2002, 2003, 2004, 2005) if you had invested in the fund when it was launched.

So, when you hear the return from a fund, check the tenure. If it is a one-year tenure, the returns would be absolute. But if it is longer than a year, ask if it is absolute or annualised.