What is Annualized Total Return – Explained

An annualized total return is the return earned on an investment each year. It is computed as a geometric average of the returns of each year earned over a period. It is also known as the Compounded Annual Growth Rate (CAGR).

Annualized Total Return

What Is an Annualized Total 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.

As an investor, you want to make smart choices with your money. One way to do that is by figuring an investment’s annualized total return. The annualized total return tells you the average return (or loss) of an investment over a 12-month period. It’s often given as a percentage.

Formula for Annualized Return

You can find annualized total returns for many types of investments, including stocks, bonds, mutual funds, real estate, and more. By doing so, you can compare two distinct types of investments, such as a stock purchase vs. a real estate investment. You can do it even if these investments are held during different periods of time.

Where:

  • R1 is the year 1 annual return
  • R2 is the year 2 annual return, and so on
  • is the number of years

Absolute Return

Absolute returns, also known as point-to-point returns, calculate the simple returns on initial investment. To calculate this return all one needs is the beginning value – NAV and ending NAV (present NAV). In this method, the duration of holding the fund is not important. One usually uses absolute returns to calculate returns for a period of less than one year.

Formula for absolute returns

Absolute returns = ((Present NAV – Initial NAV)/ Initial NAV) *100

How to Calculate Total Return

To calculate total return, first determine your cost basis for the asset or portfolio of assets in question. Subtract the current value of the investment from the cost basis, add the value of any income earnings. Take the resulting figure and multiply by 100 to make it a percentage figure.

Here’s the basic total return formula:

Total return = [(Current Value – Cost Basis + Distributions) / Cost Basis] x 100

Practical Applications

  • Companies use the annualized total return to forecast their financial performance assuming the present conditions will prevail.
  • Annualization helps taxpayers to convert the tax periods of less than a year to an annual period, which helps the taxpayers to plan effectively.
  • Short-term borrowing loan rates and investments are annualized for comparison purposes.

How to report annualized return

When reporting the annualized return of a particular investment, there are a few principles that must be adhered to as set forth by the Global Investment Performance Standards (GIPS). The primary principle that must be abided by is that an investment cannot report its performance to be annualized if it has not been in existence for less than one year.

So, for example, if a fund has been in operation for only two months and has earned 6%, it cannot report an annualized performance of 48%. This principle is meant to keep funds from reporting a predicted performance instead of reporting facts.

Key Takeaways

  • The annualized total return is the return that an investment earns each year for a given period.
  • It is useful when comparing investments with different lengths of time.
  • The annualized total return can be used to forecast the performance of an asset or a company. However, due to market volatility and other conditions, the predictions cannot be guaranteed.

Difference Between Annualized Return and Average Return

Calculations of simple averages only work when numbers are independent of each other. The annualized return is used because the amount of investment lost or gained in a given year is interdependent with the amount from the other years under consideration because of compounding.

For example, if a mutual fund manager loses half of her client’s money, she has to make a 100% return to break even. Using the more accurate annualized return also gives a clearer picture when comparing various mutual funds or the return of stocks that have traded over different time periods. 

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