What is Annualized Rate of Return?
Annualized rate of return is a way of calculating investment returns on an annual basis. As we invest, we often want to know how much we are earning from our investments. When we calculate our investment earnings over time, it is known as the rate of return.
However, investments come in all shapes and sizes – how do we compare the share price of Amazon to an investment in Vancouver real estate? The annualized rate of return solves such a problem by calculating the rate of return for all investments on an annual basis. It allows us to compare different types of investments over the same time frame, making it easy to see which investments are most profitable.
- The annualized rate of return calculates the rate of return on investments by averaging returns on an annual basis.
- For investors with diverse portfolios, the annualized rate of return makes it easy to compare the performance of different investments.
- The annualized rate of return differs from the annual return because it also accounts for the compounding of investment earnings over time.
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.
When to Use Annualized Rate of Return
For investors with diverse portfolios, the annualized rate of return makes it easy to compare the performance of different investments. Returns on investments, such as stocks, can change on a moment’s notice, and a 15% gain last year may be followed by a 25% loss in the current year.
For investments with volatile returns or variable interest rates, it can be difficult to accurately assess how the investments are performing. The annualized rate of return is especially useful for investments where the returns are known in terms of a dollar amount, but the actual percentage rate is unclear.
By calculating a single annualized percentage for all investments, it’s easy to see which investments are underperforming and which provide the best returns over time.
- Beginning Value of Investment – The amount initially invested
- Ending Value of Investment – The present-day value of your investments
- Number of Years – The length of your investment in years
Multiply the result by 100 to see the rate of return in percentages. If the result is negative, it means your investments suffered a loss over the time period.
Let’s assume that an individual placed their money into two different investment products:
- A $100,000 investment into a high-interest savings account with a variable interest rate. With no additional contributions, six years later, the account balance amounts to $115,900.
- An investment property in Miami that was bought for $350,000 in 2015. Five years later, the property is now worth $410,000.
With two completely different investments, which one provides the best return? We can use the annualized rate of return formula to calculate the rate of return for both investments on an annual basis.
Using the formula given above, we substitute the figures:
1) ARR = (115,900 / 100,000) (1/6) – 1
ARR = 0.02489 ≈ 2.50%
2) ARR = (410,000 / 350,000) (1/5) – 1
ARR = 0.03215 ≈ 3.21%
By using the annualized rate of return formula, we are now able to compare the returns for both investments over the same time frame. Therefore, we can conclude that the investment property in Miami provides the best return at an annualized rate of 3.21%.
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