The equivalent yearly return that an investment would have received during a specific period is used to determine the annualized rate of return. The returns of portfolios or composites for periods of less than a year may not be annualized, per the Global Investment Performance Standards. This prohibits the "projected" performance for the remaining part of the year.
Understanding annualized return
The term "annualized return," sometimes known as "annual return" or "annualized total return," refers to the geometric average of an investment's gains over the course of a year. This formula calculates the rate of return on the invested principal and ignores any free or committed funds.
The annualized rate of return can also demonstrate to an investor what they would receive if the yearly rate of return was compounded over a given time periods. Note that this computation does not reveal the negative changes, volatility, or price swings that may occur in the future with this investment.
Many investors measure an investment's annualized return across multiple years because the return rate during a single year isn't always the best reflection of its value. If you want to see how your investment has performed over a longer period of time, you may either calculate the annualized return or combine the years together.
An investor can compare their investment's return to similar investments using the annualized return calculation.
Calculating Annualized Return
To calculate your investment's annualized return, use the formula below:
Annualized Return = (1+ R) ^ (1 / N) - 1
R = return
N = number of years
The total return on an investment must be known before calculating the annualized rate of return. You can calculate your return by dividing your initial investment by its final value. The initial investment or the initial value of your portfolio is used as the denominator in this formula. The portfolio's ending value is its total value as at the end of the time period being analyzed.
Having determined the total return, you can then determine the annualized return. The "1" that is divided by "N" in the exponent of the annualized return formula stands for the unit of measurement, in this case one year. You may figure out the annualized rate of return by substituting "365" for "1" in the daily rate of return formula.
In this equation, N is the number of time intervals. If you wanted to figure out the compounded annual rate of return over a ten-year period, you'd insert "10" into the "N" field.
Here is an illustration of how to compute an annualized return:
(1 + 5.8) ^ 1/10 - 1 = 0.21
If you invest in this for ten years, you can expect an annualized return of 21%.
Annualized return vs. average return
The computations for an annualized return and an average return may look identical at first glance, but there are important distinctions between the two measures of performance. Knowing the distinctions between the two calculations and the advantages of each will help you choose the right one for evaluating your assets.
The annualized return, or geometric average, is the rate of return on an investment calculated by dividing the total gain or loss over a given time period. This method is helpful since it takes into consideration the cumulative effect of the return rates over time. It can also help with investment selections by giving a more complete picture of the equities traded over time.
Average returns, also called simple average returns or mean return, are calculated by taking the sum of all the annual returns and dividing it by the number of years covered by the analysis. This method does not allow for the comparison of mutual funds or equities and does not account for compounding.
Explaining Annualized Return
Following the guidelines established by the Global Investment Performance Standards is essential for reporting the annualized return of an investment (GIPS). An investment cannot submit its performance to be annualized if it has been in existence for less than a year, which is the basic guideline that must be followed.
Therefore, a fund that has only been open for two months and has earned 4% cannot claim to have achieved an annualized performance of 38%. This rule exists to prevent mutual funds from exaggerating their past performance in favor of future projections.
An Annualized Return Example
Here's how to figure out your investment's annualized return:
Over a period of five years, an investor's portfolio goes from a starting value of $20,000 to a final value of $35,000. To determine the total return rate (required to compute the annualized return), the investor divides the ending value by the starting value, or (35000 - 20000) / 20000 = 0.75. A total return rate of 0.75 percent is generated for the investment.
Following this, the investor must calculate the annualized return: 1 + (Return / N) - 1. The following formula allows the investor to make calculations based on the data provided: (1 + 0.75) ^ (1 / 5) - 1. The steps taken to arrive at the solution to this formula are as follows:
1 + 0.75 = 1.75
1.75 ^ (1 / 5 or .2) = 1.12
1.12 - 1 = .12 or 12%
The investor's portfolio increased in value from $20,000 to $35,000 over a five-year period, for an annualized return of 12%.