What Is an Annualized Rate of Return?
An annualized rate of return is calculated as the equivalent annual return an investor receives over a given period. The Global Investment Performance Standards dictate that returns of portfolios or composites for periods of less than one year may not be annualized. This prevents "projected" performance in the remainder of the year from occurring.
Key Takeaways
- The annualized rate of return reflects investment returns on an annual basis.
- The rate of return looks at gains or losses on investments over varying periods of time,while the annualized rate looks at the average returns on a yearly basis.
- The annualized rate of return is expressed as a percentage and is consistent over the years that the investment has provided returns.
- It differs from the annual performance of an investment, which can vary considerably from year-to-year.
Understanding Annualized Rate
Annualized returns are scaled down to a 12-month period. This scaling process allows investors to objectively compare the returns of any assets over any period.
Tip
Keep in mind that transaction fees will affect the amount in your investment portfolio. Your investment portfolio might have a 5% annualized return, for example, but it could also have ongoing annual fees that reduce the portfolio value.
Calculation Using Annual Data
Calculating the annualized performance of an investment or index using yearly data usesthe following data points:
P = principal, or initial investment
G = gains or losses
n = number of years
AP = annualized performance rate
The generalized formula, which is exponential to take into account compound interest over time, is:
AP = ((P + G) / P) ^ (1 / n) - 1
Annualized Rate of Return Examples
For example, assume an investor invested $50,000 into a mutual fundand, four years later, the investment is worth $75,000. This is a $25,000 gain in four years. Thus, the annualized performance is:
AP = (($50,000 + $25,000) / $50,000) ^ (1/4) - 1
In this example, the annualized performance is10.67 percent.
A $25,000 gain on a $50,000 investment over four years is a 50 percent return. It is inaccurate to say the annualized return is 12.5 percent, or 50 percent divided by four,because this does not take into effect compound interest. If reversing the 10.67 percent result to compound over four years, the result is exactly what is expected:
$75,000 = $50,000 x (1 + 10.67%) ^ 4
It is important not to confuse annualized performance with annual performance. The annualized performance is the rate at which an investment grows each year over the period to arriveat the final valuation. In this example, a 10.67 percent return each year for four years grows$50,000 to $75,000. But this says nothing about the actual annual returns over the four-year period. Returns of 4.5 percent, 13.1 percent, 18.95percent and 6.7percent grow$50,000 into approximately $75,000. Also, returns of 15 percent, -7.5 percent, 28percent, and 10.2percent provide the same result.
Using Days in the Calculation
Industry standards for most investments dictate the most precise form of annualized return calculation, which uses days instead of years. The formula is the same, except for the exponent:
AP = ((P + G) / P) ^ (365 / n) - 1
Assume from the previous example that the fund returned $25,000 over a 1,275-day period. The annualized return is then:
AP = (($50,000 + $25,000) / $50,000) ^ (365/1275) - 1
The annualized performance in this example is 12.31 percent.
What is the difference between annualized rate of return and annual performance?
The annualized rate of return of an investment is expressed as a percentage consistent over the years that an investment provides returns. Annualized return also takes compound interest into account. Annual performance is a snapshot of an investment's gains and losses in a single year, which can change substantially depending on the year.
How can the annualized rate of return help you understand your investments?
Investors hold different types of investments for varying periods of time. Annualized rate of return can help investors compare the performance of diverse investments.
What are the limitations of an annualized rate of return?
Annualized rate of return can be a useful tool to understand your investment outlook, but it is not a guarantee. Market volatility and other outside forces can change an investment's annualized rate of return.
The Bottom Line
Annualized rate of return calculates return on investment as an annual average over a given period of time. Investors can use the annualized rate of return to compare diverse investments over the same set period. Annualized rate of return can change over time, influenced by market conditions.
