An annualized total return is the return earned on an investment each year. It is computed as a geometric average of the returns of each year earned over a period. It is also known as the Compounded Annual Growth Rate (CAGR).
The annualized rate of return allows investors to compare investments with different time lengths. While it gives investors a performance preview of the investments, the annualized total return does not suggest anything about the price fluctuations or unpredictability of the investments.
Formula for Annualized Total Return
1. If an investor is given the annual rate of returns for each year over the investment period, the annualized total return is calculated using the following formula:
R1 is the year 1 annual return
R2is the year 2 annual return, and so on
n is the number of years
For example, an investor previously purchased 150 shares for $20 each and decided to hold onto these shares for two years. The stock rises 15% in the current year and increases by 12% the year after. What will be the annualized total return of the investment held for two years?
The investor earns a return of 13.5% each year for the two years the stocks were held.
2. If the cumulative return is known, the annualized total return can be computed for a given period, and the investment period does not need to be in years. An investment can be held for a given number of days and, in that case, the annualized total return can be calculated using the formula:
R is the cumulative return
For example, assume an investor held an investment for 650 days, which earned a cumulative return of 15.75%. What will be the annualized total return on the investment?
Here, an investment providing an aggregate return of 15.75% earns an annualized total return of 8.56%.
3. If an investor is given the initial and final dollar values of the investment, the annualized total return can be computed using the following formula:
For example, assume that an investor previously purchased 100 shares for $12 each and decided to hold onto the shares for two years. The investor receives $1.50 per share in cash dividends each year. After two years, the investor decides to sell all the shares at $15. What is the rate of return during the two years that the investor owned the shares?
Initial value of investment = $12 * 100 = $1,200
Cash received as dividends over two-year period = $1.50 * 100 * 2 = $300
Value from selling the shares = $15 * 100 = $1,500
Hence, the final value of investment = $300 + $1,500 = $1,800
Annualized Total Return:
Therefore, the investor earns an annualized return of 22.47% on the investment.
Companies use the annualized total return to forecast their financial performance assuming the present conditions will prevail.
Annualization helps taxpayers to convert the tax periods of less than a year to an annual period, which helps the taxpayers to plan effectively.
Short-term borrowing loan rates and investments are annualized for comparison purposes.
Absolute Return vs. Annualized Total Return
An absolute return or total return shows how the investment performed with no regard for the period of investment. It tells an investor the amount of funds earned by the investment and measures the percentage gain or loss with respect to the initial investment value.
For example, if an investor invested $20,000 and receives $25,000 at the end of three years, the investment provided a total return of (25,000 – 20,000) / 20,000 = 0.25 (i.e., 25%). However, it does not consider the period of three years that the investor dedicated to the security.
While calculating an absolute return is simple, it cannot be used to compare investments with different time periods. On the contrary, an annualized total return expresses the return on investment in terms of one year. Hence, investments with different time frames can be easily compared.
For example, between two investments with annualized total returns of 8.5% and 9.8%, respectively, it would be reasonable to choose the latter. The annualized total return considers the effect of compounding and either projects or decreases the time period of absolute return to one year.
The annualized total return is the return that an investment earns each year for a given period.
It is useful when comparing investments with different lengths of time.
The annualized total return can be used to forecast the performance of an asset or a company. However, due to market volatility and other conditions, the predictions cannot be guaranteed.