What is Annualized Rate of Return?

What is 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.

The annualized rate of return is a process for determining 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 returns on a yearly basis.

How does Annualized Rate of Return Work?

The annualized rate of return works by calculating the rate of return on investments for any length of time by averaging the returns into a year-long time frame. The calculation accounts for all the losses and gains over time and provides a measure of performance that equalizes all investments over the same time period.

The annualized rate of return differs from the annual return because the former is an average that also accounts for the compounding of investment earnings over time.

Relevance and Use of Annualized Rate of Return

It is important to understand the concept of an annualized return rate because it scales down the overall return to a comparable period and averages out the gains and losses during the holding period. As such, it is useful for comparing the sustainable performance of different assets over a longer time horizon.

The fund managers and portfolio analysts predominantly use this formula to objectively compare the returns of a variety of assets, such as bonds, ETFs, stocks, mutual funds, commodities, etc.

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Annualized Rate of Return Examples

For example, assume an investor invested $50,000 into a mutual fund and, 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 is 10.67 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 arrive at 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, 18.95 percent and 6.7 percent grow $50,000 into approximately $75,000. Also, returns of 15 percent, -7.5 percent, 28 percent, and 10.2 percent provide the same result.

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