Investors often compare different investments to decide where to allocate their money. However, investments usually span different time periods. Some last months, others last years. This is where the annualized return formula becomes essential, as it converts total returns into an equivalent yearly rate, allowing fair comparisons across investments.
This article explains the annualized return formula, its meaning, how it works, and practical examples to help you understand and apply it confidently.
What Is Annualized Return?
Annualized return is the average yearly rate of return earned by an investment over a specific period, assuming the investment grows at a constant rate each year.
Unlike simple or absolute returns, annualized return accounts for:
- Time duration
- Compounding effect
- Consistency across different investment periods
In Simple Terms:
Annualized return tells you “What yearly return would give the same final value if the investment grew evenly every year?”
Why Annualized Return Matters
Annualized return is widely used because it:
- Allows fair comparison between investments with different durations
- Reflects the power of compounding
- Helps investors assess long term performance
- Is commonly used in mutual funds, stocks, bonds, and portfolios
Example:
Comparing a 40% return in 2 years vs. a 40% return in 5 years is misleading without annualization. Annualized return solves this problem.
Annualized Return Formula
The standard formula for annualized return is:
Annualized Return = (Ending Value ÷ Beginning Value)^(1/n) − 1
Where:
- Beginning Value (BV) = Initial investment
- Ending Value (EV) = Final value of investment
- n = Number of years the investment was held
To express the result as a percentage, multiply by 100.
Understanding the Formula Step by Step
- Divide the final value by the initial value
This shows total growth. - Raise the result to the power of (1 ÷ number of years)
This spreads growth evenly across each year. - Subtract 1
Converts the growth factor into a return rate.
Example 1: Simple Annualized Return Calculation
Investment Details:
- Initial Investment: $10,000
- Final Value: $15,000
- Investment Period: 3 years
Step-by-Step Calculation:
Annualized Return = (15,000 ÷ 10,000)^(1/3) − 1
Step 1: Insert values
Annualized Return = (15,000 ÷ 10,000)^(1/3) − 1
Step 2: Simplify the fraction
15,000 ÷ 10,000 = 1.5
Annualized Return = (1.5)^(1/3) − 1
Step 3: Calculate the exponent
(1.5)^(0.3333) ≈ 1.1447
Annualized Return = 1.1447 − 1
Step 4: Final result
Annualized Return = 0.1447
Final Answer:
Annualized Return ≈ 14.47% per year
This means the investment grew as if it earned 14.47% every year for three years.
Example 2: Comparing Two Investments
Investment A:
- Return: 25%
- Time: 1 year
Investment B:
- Return: 60%
- Time: 4 years
Annualized Return for Investment A:
Since it’s one year, annualized return = 25%
Annualized Return for Investment B:
Annualized Return = (1.60)^(1/4) − 1
(1.60)^(0.25) ≈ 1.125
Annualized Return = 1.125 − 1 = 0.125
Final Answer:
- Investment A: 25% per year
- Investment B: 12.5% per year
Even though Investment B has a higher total return, Investment A performs better annually.
Annualized Return vs Absolute Return
| Feature | Annualized Return | Absolute Return |
|---|---|---|
| Time Considered | Yes | No |
| Compounding | Yes | No |
| Comparison Use | Excellent | Limited |
| Accuracy Over Long Periods | High | Low |
Example:
- Absolute return of 50% over 5 years ≠ 50% per year
- Annualized return shows the true yearly growth
Annualized Return vs CAGR
Annualized return is often confused with CAGR (Compound Annual Growth Rate).
Key Difference:
- CAGR is a type of annualized return assuming smooth growth
- Annualized return can also apply to volatile investments using average compounding
In most long-term investments, annualized return and CAGR are used interchangeably.
Example 3: Mutual Fund Investment
- Initial Investment: $5,000
- Value after 7 years: $11,000
Step 1: Given
Beginning Value = 5,000
Ending Value = 11,000
Number of years (n) = 7
Step 2: Apply the formula
Annualized Return = (11,000 ÷ 5,000)^(1/7) − 1
Step 3: Simplify
11,000 ÷ 5,000 = 2.2
Annualized Return = (2.2)^(1/7) − 1
Step 4: Calculate
(2.2)^(0.1429) ≈ 1.119
Annualized Return = 1.119 − 1
Step 5: Final result
Annualized Return = 0.119
Annualized Return:
11.9% per year
This helps investors compare the fund against market benchmarks or other funds.
Limitations of Annualized Return
While useful, annualized return has some limitations:
- Assumes steady growth
Real markets fluctuate year to year. - Ignores volatility
Two investments with the same annualized return may have very different risk levels. - Not suitable for short-term analysis
Small time frames can distort results.
For better insights, use annualized return along with risk metrics like standard deviation or Sharpe ratio.
When Should You Use Annualized Return?
Use annualized return when:
- Comparing investments of different durations
- Evaluating long-term performance
- Reviewing portfolio growth
- Analyzing mutual funds or ETFs
Avoid using it alone for:
- Short-term trading decisions
- Highly volatile assets without risk analysis
Frequently Asked Questions (FAQs)
Yearly return shows actual performance in a specific year, while annualized return averages performance across multiple years assuming compounding.
Yes. If the ending value is lower than the beginning value, the annualized return will be negative, indicating a loss.
In most long term investments, yes. CAGR is a commonly used form of annualized return that assumes smooth, compounded growth.
Annualized return accounts for time and compounding, making it more accurate and comparable across investments.
No. Beginners should use annualized return along with risk indicators, investment goals, and market conditions for better decision-making.
