What Is Annualized Total Return?

Annualized Total Return Explained

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Accurately determining annualized total return of an investment is critical to making smart decisions over the course of one’s investing life. Calculating annualized total return provides the geometric average return (or loss) of an investment, often used as a percentage.

Annualized total return can be determined for numerous types of investments, including stocks, bonds, mutual funds, commodities, real estate, or small businesses. By determining annualized total return, an investor can compare two distinctly different types of investments—a stock purchase versus a real estate investment, for example—even if the investments are held over different periods of time.

This type of performance evaluation allows investment managers to make strategy changes with the intent to improve returns or reduce risk. For that reason, it is good to understand annualized total return and how it is calculated.

What Is Annualized Total Return?

Annualized total return calculates the average amount of money earned by an investment on an annual basis, whether that is over the course of a calendar year or an alternative 12-month period. 

Annualized total return is different than average annual return, in that annualized total return accounts for compounding over an investment period, while average annual return does not.

Calculating annualized total return is helpful when the return of an investment in dollar terms is known, but the actual percentage rate over the course of an investment is not. It also allows you to compare the return of various investments over different periods of time. For example, an investor may wish to compare the performance of a stock that was held for a certain number of years with the increase in value of real estate that was held for a different number of years. Or, one could compare the performance of two mutual funds with a change in value held for a different number of years.

How Annualized Total Return Works

Let’s say you want to compare the performance of two mutual funds. To do so, an investor needs to know two variables: the return for a given period of time and how long the investment was held.

The equation for finding annualized total return of an investment is:

In the above equation, “R” is the appropriate return and “N” is the number of years the investment was held.

Let’s look at this for an example of someone who owns a mutual fund that has annual returns over a four-year period of 7%, 10%, 8%, and 12%. When plugged in, the equation would be:

Annualized Total Return = {(1 + .07) x (1 + .10) x (1 + .08) x (1 + .12)1 / 4 - 1 or 1.09232 - 1 = .09232 x 100 (to express as a percent) = 9.23%.

So, the annualized total return of the mutual fund is 9.23%. If an investor then wanted to compare the annualized return of this mutual fund with another that holds different annual returns across a two-year period, he would repeat the equation, inputting the new percentages for R, and two for N. 

Annualized Total Return vs. Average Annual Return

Often, an investment is assessed in terms of average annual return rather than annualized total return. It is important to note that these two metrics are different. 

Average annual return is simply the total return over a time period divided by the number of periods that have taken place. It ignores the important element of compounding, which annualized total return takes into account. The formula for calculating average return is:

Average return is often used to assess the performance of a mutual fund or compare mutual funds. If a mutual fund returned 12% one year, lost 20% the next year, and gained 15% in the third year, the three-year average annual return would be:

Average Return = (12% + -20% + 15%) / 3 years = 2.33%

The annualized total return for that same three-year period is significantly different. Plugging the same numbers into the formula for calculating annualized total return looks like this:

Annualized Total Return = {(1.12) (.80) (1.15)}1/3 – 1 = 0.0100 x 100 ≈ 1.00%

In the year the investment lost 20%, you have 80% of the balance from the end of the first year, which is why you multiply by .80. You can see the impact that second year’s loss has on the annualized total return versus the average annual return. Annualized total return accounts for compounding; the loss of 20% in year two significantly drags on the positive impact of compounding.

The Benefit of Annualized Total Return

Providers of mutual funds and other investment vehicles prefer to cite annualized total return over the average return because it is generally a clearer snapshot of the worth of the investment. Annualized total return gives investors a preview of the performance of investments; however, the metric does not give any indication of price fluctuations or volatility of an investment’s performance. When looking at metrics, investors tend to put a higher value net earnings, or the amount of money your investment has made or lost over a period of time after fees have been deducted. 

Key Takeaways

  • Annualized total return allows investors to compare two distinctly different investments over varying periods of time. 
  • Providers of mutual funds and other investment vehicles prefer to cite annualized total return over the average return because it is generally a clearer snapshot of the worth of the investment, as it amounts for compounding.
  • While the metric provides a preview of an investment’s performance, it does not give any indication of price fluctuations or volatility.