Calculating and Formulating Annualized Total Return

What Is Annualized Total Return?

Annualized total return reflects the geometric average annual earnings of an investment during a specified period. It is calculated using a geometric average to illustrate what an investor would yield over time if the annual returns were compounded.

While annualized total return offers insight into an investment’s performance, it does not convey information on volatility or price fluctuations.

## Key Takeaways:
– Annualized total return signifies the geometric average annual earnings of an investment.
– The formula calculates what an investor would earn over time if annual returns were compounded.
– It requires two variables: returns for a specific period and the duration of investment.

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Understanding Annualized Total Return

To grasp the concept of annualized total return, let’s compare the hypothetical performances of two mutual funds. Consider the annualized rate of return over five years for Fund A and Fund B:

• Mutual Fund A Returns: 3%, 7%, 5%, 12%, and 1%
• Mutual Fund B Returns: 4%, 6%, 5%, 6%, and 6.7%

Despite both funds having a 5.5% annualized rate of return, Fund A exhibits higher volatility compared to Fund B, showcasing the importance of reviewing risk metrics in investment analysis.

Annualized Return Formula and Calculation

The annualized rate of return formula necessitates only two variables: the returns for a specific period and the investment holding duration. The formula is:

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For instance, by using the annual returns of Fund A, where each “r” denotes a return percentage and “n” marks the years held, we can calculate its annualized return.

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An annualized return is not restricted to yearly data; it can be derived from cumulative figures for any period, adjusting the formula accordingly.

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For instance, if an investment’s cumulative return over 575 days is 23.74%, the annualized return can be calculated as:

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Difference Between Annualized Return and Average Return

While simple averages suffice for independent numbers, annualized return is preferred due to compounding interdependencies among yearly gains or losses.

Annualized return accuracy is paramount for comparing mutual funds or stock returns over distinct periods to ascertain performance accurately.

Reporting Annualized Return

As per Global Investment Performance Standards (GIPS), investments must exhibit a minimum 365-day history to annualize performance accurately.

Calculating annualized total return must rely on historical performance data rather than future predictions, ensuring precise reporting.

How Is Annualized Total Return Calculated?

Annualized total return is a critical metric that captures an investment’s average annual performance over a specified period. It uses a geometric average to consider compounding effects, also known as the compound annual growth rate (CAGR).

What Is the Difference Between an Annualized Total Return and an Average Return?

The key difference lies in how the annualized total return incorporates compounding, unlike the average return.

What Is the Difference Between the Annualized Total Return and the Compound Annual Growth Rate (CAGR)?

While the annualized total return and CAGR aim to capture geometric returns, the distinction lies in the approach of using single or multi-year returns. Conceptually, they are similar despite the presentation variance.

The Bottom Line

Annualized total return provides insight into an investment’s average annual earnings over a specified period. By considering compounding through a geometric average, the metric illustrates the annual earnings potential. Although it offers a snapshot of performance, it doesn’t account for volatility or price fluctuations.