Most mutual funds are aimed at long-term investors and seek relatively smooth, consistent growth with less volatility than the market as a whole. Historically, mutual funds tend to underperform compared to the market average during bull markets, but they outperform the market average during bear markets. Long-term investors usually have a lower risk tolerance and are commonly more concerned with minimizing risk in their mutual fund investments than they are with maximizing gains.
As to what constitutes a good average annual return for a mutual fund, "good" is largely defined by the individual investor's expectations and desired level of return. Most investors are likely to be satisfied by a return that roughly mirrors the average return of the overall market and consider returns that meet or exceed that goal to constitute a good annual return level. However, investors seeking higher returns would be disappointed by that level of return on investment.
Economic conditions and the performance of the market are also important considerations in determining a good return on investment. For example, in the event of a severe bear market during the year, with stocks dropping on average 10 to 15%, a fund investor who realized a 3% profit for the year might consider that an excellent return. Under different, and more positive market conditions, the investor would be very dissatisfied with that same level of return.
Annual Return vs. Annualized Return
To get a clear picture of a mutual fund's return over time, it's important for investors to understand the difference between annual return and annualized return. Annual return is defined as the percentage change in an investment over a one-year period; annualized return is the percentage change in an investment measured over periods of time shorter or longer than one year but stated as a yearly rate of return.
Being able to calculate the annual return of a company or other investment gives investors the ability to analyze performance over any given year the investment is held. The annual return calculation is used more frequently among investors because it is relatively simple compared to annualized return. To calculate annual return, first determine the initial price of the investment at the beginning of the holding period followed the price of the investment at the end of the one-year period. The initial price is subtracted from the end price to determine the investment's change in price over time.
That change in price is then divided by the initial price of the investment. For example, an investment with a stock price of $50 on January 1 that increases to $75 by December 31 of the same year has a change in the price of $25. That amount divided by the initial price of $50 results in a 0.5, or 50% increase for the year. Although the annual return provides investors with the total change in price over the one-year period, the calculation does not take into account the volatility of the stock price over that time horizon.
In contrast, annualized return can be used in a variety of ways to evaluate performance over time. To calculate the annualized rate of return, first determine the total return. This is the same calculation as annual return (ending investment price - initial investment price / initial investment price) but is based on the full investment holding period, regardless of whether it's shorter or longer than a one-year period.
From there, the annualized total return can be determined by plugging the corresponding values into the following equation: (1+total return)^1/N - 1. The variable N represents the number of periods being measured, and the exponent 1 represents the unit of one year being measured. For example, a company with an initial price of $1,000 and an ending price of $2,500 over a seven-year period would have a total return of 150% (2,500 - 1,000 / 1,000). The annualized return equates to 13%, with 7 substituted for the variable N: (1 + 1.50)^1/7 - 1.
The Bottom Line
Before investing in a mutual fund, it's important for investors to understand their individual goals for the investment over their specified time horizon. Knowing the expected return means the investor can measure the mutual fund's performance over specific time periods and determine whether or not the investment is performing in a manner that will meet their objectives.