CandleFocus Glossary Editor
Annualized total return is a method of measuring the performance of an investment over time. It calculates the geometric average amount of money earned by an investment each year, given the total return throughout a given time frame. The annualized return formula is used to evaluate the returns of an investment if the returns were compounded annually. This formula provides a more consistent and accurate rate of return than simply looking at the investment's total return, which may be skewed if the investor held it for a long period of time.
The annualized total return formula is fairly easy to calculate. An investor only needs two variables to complete the calculation: the returns for a given period and the time the investment was held. However, for the most accurate result the yearly returns should be adjusted for inflation.
To understand how to use the formula, let's examine a hypothetical situation. Suppose an investor purchased shares in XYZ Corporation on January 1 2019. On January 1 2020 the value of the shares had risen to $200. If, by January 1 2021, they had risen to $210, the annual return would be $10, or 5%. To calculate the annualized rate of return, the investor would first deduct $200 (the original value) from the value at the end of the holding period ($210). The difference is $10, the annual return. The investor would then divide this $10 by the original value of the shares ($200), giving a result of 0.05. The investor would then use the formula R=100(1+x)^n, where R is the rate of return, x is the rate of return from the previous year and n is the number of years held, to calculate the rate of return over the two-year period. In this case, the formula would be: R = 100 (1 + 0.05)^2 = 110.25%. This is the annualized total return for the investment.
The annualized total return formula is a useful tool for measuring an investment's performance over a period of time. By using the formula, investors can gain a more accurate and consistent measure of their returns than simply looking at the total return. It is important to note that just as the total return may be skewed over a long time frame, so too can the annualized total return. To gain an even more accurate result it is recommended to adjust the returns for inflation.
The annualized total return formula is fairly easy to calculate. An investor only needs two variables to complete the calculation: the returns for a given period and the time the investment was held. However, for the most accurate result the yearly returns should be adjusted for inflation.
To understand how to use the formula, let's examine a hypothetical situation. Suppose an investor purchased shares in XYZ Corporation on January 1 2019. On January 1 2020 the value of the shares had risen to $200. If, by January 1 2021, they had risen to $210, the annual return would be $10, or 5%. To calculate the annualized rate of return, the investor would first deduct $200 (the original value) from the value at the end of the holding period ($210). The difference is $10, the annual return. The investor would then divide this $10 by the original value of the shares ($200), giving a result of 0.05. The investor would then use the formula R=100(1+x)^n, where R is the rate of return, x is the rate of return from the previous year and n is the number of years held, to calculate the rate of return over the two-year period. In this case, the formula would be: R = 100 (1 + 0.05)^2 = 110.25%. This is the annualized total return for the investment.
The annualized total return formula is a useful tool for measuring an investment's performance over a period of time. By using the formula, investors can gain a more accurate and consistent measure of their returns than simply looking at the total return. It is important to note that just as the total return may be skewed over a long time frame, so too can the annualized total return. To gain an even more accurate result it is recommended to adjust the returns for inflation.