Annualized Rate of Return

What Is An Annualized Rate of Return?

‍An annualized rate of return is a way to measure and track the performance of an investment over time. There are many different methods for computing and using this rate.

The annualized return on a mutual fund or financial asset means that its performance can be tracked and compared more easily over time, allowing you to see how much money you would have if you left your investment to grow for a specific amount of time. 

An annualized rate of return is a measurement that allows investors to compare one stock with another or one asset class with another. There are two main ways of measuring an annualized rate of return: simple and effective. Each has its own benefits and drawbacks depending on the situation and the information desired from the data. Let’s take a look at each of them.

What Is a Simple Annualized Return?

The simple annualized return is the basic way of measuring an annualized rate of return. It is calculated by multiplying the annual percentage gain by the number of years it took to achieve that gain. So, a 10% gain in one year would be expressed as a 10% return in one year. A 5% gain per year for two years would be expressed as a 10% return in two years.

What Is an Effective Annualized Return?

The effective annualized return takes into account the compounding effect. It works similarly to the simple annualized return – however, the main difference is that you need to take the increase in the amount of capital every period to calculate the future amount. For example, a person invested $1,000 in a savings account at a 10% return rate. If the interest is being compounded quarterly, there will be an increase in the amount of capital at the end of each quarter, and the amount of interest in the next quarter will be higher than the previous quarter. Therefore, the person will have earned $25 in interest after the end of the first quarter, making the capital amount rise up to $1,025. Now the next quarter, along with the $25, he will earn an additional amount of $0.63 in interest.

Annualized Rate of Return Formula

Annualized Return can be calculated using the following formula: 

Ending Value = Price of investment at the end of the period

Beginning Value = Price of investment at the beginning of the period

n = Number of years

One may also replace 1/n with 365/n for more accurate results. 

Limitations of Using the AROR Calculation

Both methods of calculating an annualized return have limitations, depending on the situation. The simple annualized return method can be misleading if the investment returns don’t occur evenly throughout the year.