What Is an Annual Return?
An annual return is the return that an investment generates over a year. It is expressed as a time-weighted annual percentage. Sources of returns can include dividends, returns of capital, and capital appreciation. Rather than a simple arithmetic mean, the rate of annual return represents a geometric mean.
Key Takeaways
- An annual or annualized return measures how much an investment has increased on average each year during a specific period.
- The annualized return is calculated as a geometric average, offering a more accurate reflection of annual return compounded over time.
- An annual return is more beneficial than a simple return when assessing investment performance over time or comparing different investments.
- Annual return calculations are applicable to various assets, including stocks, bonds, mutual funds, ETFs, commodities, and certain derivatives.
The Significance of Annual Return
Understanding your annual return can lead to more informed investment decisions. By adjusting for compounding, it offers a precise comparison of different asset classes such as stocks, bonds, and other investment vehicles with liquidity. More accurate than simple returns, it incorporates aspects like compounding interest, making it a preferred assessment method.
Annual Returns on Stocks
The term “annualized return” describes a stock’s performance over a designated period. This calculation requires the current stock price and the purchase price, adjusted for any splits. The simple return percentage is computed first, and this figure ultimately becomes annualized.
Example:
Imagine an investor buys a stock for $20 on Jan. 1, 2024, and sells it for $35 on Jan. 1, 2029. The $15 profit combined with $2 in total dividends over five years produces a total return of $17, or 85% of the initial investment:
Total Return = ($35 - $20) + $2 = $17
Percentage Total Return = ($17 / $20) * 100 = 85%
To calculate the compound annual growth rate (CAGR):
CAGR = ((Ending Value / Beginning Value) ^(1/Years)) - 1
CAGR = ((37 / 20) ^(1/5)) - 1 ≈ 13.1%
This shows a real annualized gain of about 13.1%.
Annualized returns highlight the differences between compound and average returns and illustrate the challenges in recovering losses. For example, if you lose 50% of your investment, a 100% gain is needed to break-even.
Annual Returns on a 401(k)
When calculating the annual return of a 401(k), start by computing the total return. Substrate any contributions made during the year from the final value before calculating the return ratio:
- Determine starting and ending values.
- Adjust the final value by removing new contributions.
- Divide by the starting balance.
- Subtract 1 and multiple by 100.
The Modified Dietz Formula
Adjusting for Cash Flow with Modified Dietz Formula
The Modified Dietz formula considers cash flows in annual return computation, adjusting each period’s returns for additional accuracy.
Other Methods to Calculate Annual Return
Calculate monthly rate of return, then annualize:
Annual Rate = Monthly Rate * 12
Various online calculators can simplify these computations.
How to Calculate Overall Return on Investment
To find your overall return on investment (ROI):
- Subtract original investment costs from current value.
- Divide the result by the total invested amount, adjusted for fees and commissions.
- Multiply by 100 for the percentage.
The Bottom Line
Calculating the annual return helps evaluate or compare investments and guides your portfolio strategy for optimal growth. When in doubt, consult a financial professional for precise calculations and strategic advice.
Related Terms: CAGR, ROI, dividends, capital appreciation, derivatives, Modified Dietz formula.
References
- TIAA.org. “All FAQs About Personal Rate of Return”.
- CFI Education. “Annual Return”.
- TIAA. “All FAQs About Personal Rate of Return”.
- Investor.gov. “Annual Return”.
