What is Annualized Return?

How does annualized return play a vital role in choosing the right investment? Well, annualized returns clearly show a mutual fund’s performance over the long run. It shows the investors what they would have gained had the annual return been compounded over a certain period. 

Annualized Return, also popularly known as Compound Annual Growth Rate (CAGR), is a benchmark that calculates the average annual return of an investment, analysing the net loss or gain within a specified period. It is calculated as a geometric average considering the effects of compounding over time.  

Calculating annualized returns can benefit an investor as it shows the annual return rate’s interdependency on the return rates of preceding years. For example, a mutual fund has a 2.5% return in a year. The same fund shows a 28% annualized return over five years. This means the investment grew by an average of 5.6% each year, not just over five years.

Annualized Return Formula

To calculate the annualized return of an investment, the following formula can be used:

Annualized Return = (1 + Return) ^ (1 / N) – 1 

Here, N = number of years 

However, before calculating the annualizing return, an investor must first determine the overall return of an investment. The formula for overall return is as follows:

Overall Return = (Ending Value- Beginning Value)/ Beginning Value

Beginning Value: Amount that you have invested

Ending Value: Amount left on the portfolio at the end of the period.

How to Calculate Annualized Returns?

After calculating the overall return, annualized returns can be calculated. In the annualized return formula, the “1’’ divided by the “N” in the exponent indicates the unit measured, e.g. 2 years, 3 years. Likewise, instead of “1”, you can also use “365” to calculate the daily return on an investment. 

Further, the “N” replicates the number of measured years (periods). For example, we will use “5” instead of the “N” value to calculate the annualized returns of five years.

Let’s take a look at the following example to calculate Annualized Returns:

Return per year: 2%

N= 4

Then, Annualized Return = (1+2)^ (¼)-1 = 0.316

So, the annualized return will be 31% over a period of four years.

Example of Calculating Annualized Return

To get a better understanding of Annualized Returns, look at the following example: 

Say you start with an investment of Rs. 5,000. After 5 years, it grows to Rs. 20,000. Now, the primary thing you compute is the “overall return”, which indicates how much your investment has grown in total.

The formula for overall return is:

Overall Return = (Ending value – Beginning value)/(Beginning value) x 100

Upon filling in the numbers, we get the following:

Overall Return = (Rs.20,000 – Rs.5,000)/(Rs.5,000) x 100 = 300%

Your overall return is 3 or 300%. After calculating the overall return, you want to find out what this overall return would be if spread evenly over each of the five years. It denotes the concept of “annualized return”,  similar to finding an average yearly return that would give you the same overall growth.

The formula for annualized return is:

Annualized return = (1 + Return) ^ (1/N) – 1

Where:

• “Overall Return” is 3 or 300%
• “N” is the number of years (in this case, 5 years)

Again, we will fill in the numbers:

Annualized return = (1 + 3)^(1/5) – 1

Hence, your annualized return is 0.3195 or 31.95%, which means that your investment has grown steadily yearly; it would have increased by 31.95% per annum to reach Rs. 20,000 from Rs. 5,000 in 5 years.

Applications of Annualized Return

Annualized Return shows average yearly growth with constant investments, helping investors determine how well their investments are doing in the long run. Standardized returns over different periods make comparing various investment options and determining risk easier. Let’s understand the application of annualized returns in detail.

Also Read: What is CAGR in Mutual Funds: Calculation and Advantages

Investment Performance Evaluation

Annualized Returns calculation can help investors to compare the performance of different investments over time. It makes identifying best-performing assets easier for investors without worrying about how long it has been held. Additionally, investment performance can be evaluated through “ benchmarking”, which compares your investment’s annualized return against market indices like the Sensex & Nifty 50. 

If your annualized returns are less than the benchmark, then there is a need to adjust your strategy. This process helps determine whether your investments are well-performing or underperforming compared to the overall market. 

Future Financial Planning

Annualized returns help investors plan their future retirement or child education savings objectives. Knowing the annualized returns of your investments beforehand makes it easier to predict future growth.  For example, when it comes to education savings, it is vital to calculate whether your current investment planning will cover future education expenses.

Similarly, objective-based investing, like investing to purchase a car, shows how your investments will grow to ensure you are saving enough to achieve your goal in the planned duration. In the end, financial planning helps you to figure out how much to save or invest to meet your goals. 

Risk Assessment

The financial transactions are packed with uncertainty, which we generally call “risk”. That’s why assessing risk in an investment is crucial for investors. Annualized returns can predict risks and rewards, which investors can use during asset allocation decisions. High-risk investments, such as stocks, have higher annualized returns and high volatility, while lower-risk assets, like bonds, provide more stability but yield lower returns. 

Conclusion

Understanding the annualized return is essential for investors to better evaluate the performance of an investment and select a correct investment mix for better return. However, annualized return measures have limitations too. It presumes consistent performance of investments and does not account for unpredictability. It is helpful in future financial planning, whether it is a child’s education, buying a house, or retirement.