Annualized Rate of Return

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 concept of annualized returns is widely used in financial reporting and regulatory contexts. For example, the U.S. SEC requires mutual funds to present performance using standardized annualized figures.

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.

Annualized Rate of Return Formula

Where:

• 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.

Real-World Examples

Example 1: High-Interest Savings Account vs. Investment Property

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. Six years later, the property is now worth $420,000.

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:

• Annualized Rate of Return = (115,900 / 100,000)^(1/6) – 1

Annualized Rate of Return = 0.02489 ≈ 2.50% per year

• Annualized Rate of Return = (420,000 / 350,000)^(1/6) – 1

Annualized Rate of Return = 0.03072 ≈ 3.07% per year

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 3.07%.

Example 2: Investment With Dividends

Suppose an investor buys 100 shares of a stock at $50 per share (total investment = $5,000). Over three years:

• The stock price rises to $65 per share.
• The investor receives $200 in dividends each year (total dividends = $600).

Total Ending Value = $6,500 (stock value) + $600 (dividends) = $7,100

• Annualized Rate of Return = (7,100 / 5,000)^(1/3) – 1
• Annualized Rate of Return = 0.1238 ≈ 12.4% per year

This example shows how including dividends provides a more realistic view of returns.

Example 3: Reinvestment of Dividends

Using the same stock, assume instead that all dividends were reinvested into additional shares each year. If the reinvested dividends increase the ending portfolio value to $7,350, then:

• Annualized Rate of Return = (7,350 / 5,000)^(1/3) – 1 
• Annualized Rate of Return = 0.1368 ≈ 13.7% per year

This highlights how dividend reinvestment boosts the annualized return compared to simply taking cash dividends.

Example 4: Different Time Horizons

Investor A holds a bond that grows from $10,000 to $14,000 in 5 years.

• Annualized Rate of Return = [(14,000 / 10,000)^(1/5) – 1 
• Annualized Rate of Return = = 0.0696 ≈ 6.96% per year

Investor B holds a stock that grows from $10,000 to $14,000 in 2 years.

• Annualized Rate of Return = (14,000 / 10,000)^(1/2) – 1 
• Annualized Rate of Return = 0.1832 ≈ 18.3% per year

Even though both investments earned the same total return (40%), the annualized rate of return highlights the effect of time horizon. Shorter time frames magnify the annualized return.

Comparative Table: Annualized Rate of Return  vs IRR vs TWRR

When to Use Annualized Rate of Return vs. Other Metrics

The choice of which performance metric to use depends on the type of investment and the level of detail required in the analysis:

• Annualized rate of return is preferable when you want a quick, simplified measure of how much an investment has returned on an annual basis. It’s particularly helpful for comparing two or more investments held over different time periods. However, it should be viewed as an approximation because it assumes a steady rate of return and does not account for cash flow timing.
• IRR should be used in situations where cash flows occur at periodic intervals, such as in private equity, venture capital, or real estate investments. Since it incorporates the time value of money, IRR is essential for determining whether a project or investment is expected to meet a required rate of return.
• TWRR is most appropriate for evaluating portfolio managers or funds where investors frequently contribute or withdraw money. It neutralizes the effect of external cash flows, allowing for a fairer comparison of manager performance.

In practice, professionals often look at multiple return measures together. Annualized rate of return may provide a quick benchmark, but for deeper decision making, IRR and TWRR offer more accurate insights depending on the investment context.

Summary

The annualized rate of return is a standardized way to measure the yearly performance of an investment, regardless of how long it was held. It averages the total gains or losses over time, accounting for compounding, and expresses them as a consistent annual percentage. This makes it easier for investors to compare different types of investments, like stocks, real estate, or savings accounts, even if they span varying durations or have volatile returns. 

The annualized rate of return is especially helpful when the dollar value of returns is known, but the percentage is unclear. Unlike the basic annual return, the metric offers a more accurate, time-adjusted view of investment performance. It is related to CAGR and differs from other metrics like IRR or TWRR, which offer deeper insights in specific contexts, such as fluctuating cash flows or professional portfolio management. 

Overall, the annualized rate of return is a quick, practical benchmark for evaluating and comparing investment efficiency on an annual basis.

Additional Resources

Thank you for reading CFI’s guide on Annualized Rate of Return. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Absolute Return
• Average Return
• Diversification
• Risk and Return
• Nominal Rate of Return
• See all Capital Markets resources
• See all Wealth Management resources