Investors can hold several assets as a part of their portfolio. Usually, these assets come from various classes. Investors invest in those classes to ensure they can achieve diversification in their portfolios. However, achieving a diversified portfolio isn’t the only crucial factor when choosing assets. Investors also consider the risks and returns associated with their investments. These factors also depend on the investor’s risk tolerance.
Risks and returns dictate the mix of assets that investors choose as a part of their portfolios. The former relates to the losses investors can expect if an investment fails. Usually, risks are highly crucial in deciding the returns investors can get on their assets. However, they also impact the losses they make. For investors, considering both factors is highly crucial.
Once investors choose to include an asset as a part of their portfolio, they must track its performance. Some investments may come with regular or periodic returns. In contrast, others provide an irregular return schedule. Investors must know how to compare those investments regardless of how returns come. For that, they can use the annualized total return.
What is Annualized Total Return?
The annualized total return for an investment is its geometric average annual return over a specific time. Investors calculate it as a geometric average to know how much they would earn over that period. However, it deems that return after compounding. Essentially, the annual total return provides the geometric average amount of money an investor earns. It considers every investment individually for a given period.
The annualized total return helps investors understand how an investment performs over time. It provides a picture of its performance for a given period. However, it does not consider the volatility or price fluctuations associated with that investment. The annualized total return helps investors understand the return earned for each asset. Since it considers an annual period, it shows those returns annually.
Another name used for the annualized total return is the Compounded Annual Growth Rate (CAGR). It measures an investment’s annual growth rate over time. On top of that, it also considers the effect of compounding on that growth. It helps investors gauge and compares various investments based on their past performance. Similarly, it allows investors to project their expected future returns based on those returns.
One of the most crucial reasons investors use the annual total return is its comparability feature. It helps investors compare various assets with different time lengths. This way, it allows them to regard several investments without the timing implications. The annualized total return gives investors a performance preview of the underlying asset. However, it fails to consider risk factors when providing those returns.
How to Calculate the Annualized Total Return?
There is no single formula for the annualized total return that investors can use. Instead, they must use one of the several ways to calculate the annualized total return. This way will depend on the underlying information available to the investor. For these methods, investors will need two variables. These include the returns for an investment for a period and the time they hold it.
Method 1
An investor may have the annual rate of returns for each year for the investment period. In that case, they can use the following annualized total return formula.
Annualized total return = [[(1 + R1) x (1 + R2) x (1 + R3) x … x (1 + Rn)] ^ (1/n) – 1] x 100
In the above formula, ‘R’ refers to the annual return for a year. Therefore, ‘R1‘ is the annual return for year one and so on. ‘n’ refers to the total number of years.
Method 2
An investor may have a cumulative return for an investment. In that case, they can calculate the annualized total return for a given period. However, the investment period does not need to be in years. Investors can calculate the annualized total return for several days. Consequently, they can use the following formula for annualized total return.
Annualized total return = [[(1 + R) ^ (365 / Number of days held)] – 1] x 100
In this annualized total return formula, ‘R’ refers to the cumulative return.
Method 3
Investors may have the initial and final dollar values for investment. In this case, they can use the following annualized total return formula.
In the above formula for annualized total return, ‘n’ refers to the number of periods the investor holds the asset.
Example:
An investor invests in an asset, which they hold for 750 days. During this period, the investment earns a cumulative return of 12.5%. The investor wants to calculate the annualized total return for the asset. Since the cumulative return is available, the second method of annualized total return will apply. Therefore, the investor can calculate the amount as follows.
Annualized total return = [[(1 + R) ^ (365 / Number of days held)] – 1] x 100
Annualized total return = [[(1 + 12.5%) ^ (365 / 750)] – 1] x 100
Annualized total return = 5.90%
Similarly, the investor invested in 100 shares that came with a $20 price tag. They held those shares for five years. During those five years, the investor received a $2 dividend per share regularly for each year. After that time, they decide to sell those shares, which now have a market price of $30 per share. The investor wants to calculate the annualized total return for the investment.
However, the investor cannot use the same method to calculate annualized total returns. In this case, they can use the alternative formula for annualized total return. However, they must know the initial and final value of the investment. These are as below.
Initial value of investment = 100 shares x $20 per share = $2,000
Dividends received for five years = 100 shares x $2 per share x 5 years = $1,000
Value from selling shares = 100 shares $30 per share = $3,000
From the above information, the investor can calculate the final value of the investment as follows.
Final value of investment = Value from selling shares + Dividends received for five years
Final value of investment = $3,000 + $1,000
Final value of investment = $4,000
Based on the above information, the annualized total return will be as follows.
Annualized Total Return = [[(Final Value of Investment / Initial value of investment) ^ (1/n)] – 1] x 100
Annualized Total Return = [[($4,000 / $2,000) ^ (1 / 5)] – 1] x 100
Annualized Total Return = 14.87%
What is the Difference between Annualized Total Return and Absolute Return?
The absolute or total return represents an investment’s performance without time consideration. It shows the value of funds an investor earns on their investment. Similarly, it also measures the gain or loss made based on their initial investment value. Usually, these items come as a percentage of that value. Most investors use the absolute return when gauging investments.
However, the annualized total return is different in this aspect. This amount expresses the return on investment for a defined period. In most cases, it considers a year. Absolute returns can be crucial in helping investors know how much they earn on an investment. However, it cannot compare several assets with different periods.
Moreover, there is a difference between annualized returns and average total returns. Usually, average returns are helpful if the underlying numbers don’t rely on each other. In other words, they are independent of each other. The annualized return is beneficial since the gains or losses don’t depend on the period. Since it considers compounding, it can be more critical.
Conclusion
Investors hold investments in various asset classes. These investments may provide returns in different periods. Therefore, investors must know how to compare them. The annualized total return provides the geometric average returns for a given period. Investors can calculate it under various methods based on the data available.
