Loading the player...

What is an 'Annualized Total Return'

An annualized total return is the geometric average amount of money earned by an investment each year over a given time period. It is calculated as a geometric average to show what an investor would earn over a period of time if the annual return was compounded. An annualized total return provides only a snapshot of an investment's performance and does not give investors any indication of its volatility.

BREAKING DOWN 'Annualized Total Return'

When comparing annualized total return between two funds, take for example the following two hypothetical mutual funds and their annual returns over a five-year period:

Mutual Fund A Returns: 3%, 7%, 5%, 12% and 1%

Mutual Fund B Returns: 4%, 6%, 5%, 6%, and 6.7%

Both mutual funds have annualized returns of 5.5%, but Mutual Fund A is much more volatile. Its standard deviation is 4.2%, while Mutual Fund B's standard deviation is only 1%. Even when analyzing an investment's annualized return, it is important to review risk statistics.

Annualized Return Formula and Calculation

The generalized formula to calculate annualized return needs only two variables: the returns for a given period of time and the time the investment was held. The formula is:

For example, take the annual returns of Mutual Fund A above. An analyst substitutes each of the "r" variables with the appropriate return, and "n" with the number of years the investment was held. In this case, five. The annualized return of Mutual Fund A is calculated as:

Annualized Return = ((1 + 3%) x (1 + 7%) x (1 + 5%) x (1 + 12%) x (1 + 1%)) ^ (1 / 5) -1 = 130.9% ^ (0.20) -1 = 105.55% - 1 = 5.53%

Annualized return does not have to be limited to yearly returns. If an investor has a cumulative return for a given period, even if it is a specific number of days, an annualized performance figure can be calculated; however, the formula must be slightly adjusted to:

For example, assume a mutual fund was held by an investor for 575 days and earned a cumulative return of 23.74%. The annualized return would be:

Annualized Return = (1 + 23.74%) ^ (365 / 575) - 1 = 114.5% - 1 = 14.5%

Annualized Return's Difference From Average Return

Calculations of simple averages only work when numbers are independent of each other. The annualized return is used because the amount of investment lost or gained in a given year is interdependent with the amount from the other years under consideration because of compounding. For example, if a mutual fund manager loses half of her client's money, she has to make a 100% return to break even. Using the more accurate annualized return also gives a clearer picture when comparing various mutual funds or the return of stocks that have traded over different time periods. 

Reporting Annualized Return

According to the Global Investment Performance Standards (GIPS), a set of standardized, industry-wide principles that guide the ethics of performance reporting, any investment that does not have a track record of at least 365 days cannot "ratchet up" its performance to be annualized. Thus, if a fund has been operating for only six months and earned 5%, it is not allowed to say its annualized performance is approximately 10%, since that is predicted future performance instead of stating facts from the past.

RELATED TERMS
  1. Annual Return

    Annual return is the compound average rate of return for a stock, ...
  2. Gross Rate of Return

    Gross rate of return is the total rate of return on an investment ...
  3. Mutual Fund

    Mutual funds combine money from many investors to invest in a ...
  4. Average Annual Return - AAR

    Average annual return (AAR) refers to the mean of a fund or security's ...
  5. Yearly Rate Of Return Method

    The yearly rate of return method is the rate of return achieved ...
  6. Accounting Rate of Return (ARR)

    The accounting rate of return measures the amount of profit, ...
Related Articles
  1. Investing

    How to calculate your investment return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  2. Investing

    What You Need to Know About Mutual Funds

    Mutual funds are a good investment opportunity, but investors should know how they operate.
  3. Investing

    When to buy a mutual fund

    Doing a little research can help you find out if mutual funds are a good fit for your portfolio.
  4. Investing

    Mutual Fund Due Diligence: 5 Things to Look Out for in Quarterly Reports

    Learn about five important items found in a mutual fund's annual and quarterly reports and why investors should pay attention to changes in these items.
  5. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  6. Investing

    The Uses And Limits Of Volatility

    Check out how the assumptions of theoretical risk models compare to actual market performance.
  7. Investing

    How Absolute Return Funds Differ from Mutual Funds

    Absolute return funds use strategies that are more complex than traditional mutual funds.
  8. Investing

    The Most Important Question to Ask Before Investing

    Before investing, ask yourself, "Why am I risking capital in the financial markets?"
RELATED FAQS
  1. What metrics should I use to evaluate the risk-return tradeoff for a mutual fund?

    Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the risk-reward ... Read Answer >>
  2. How do I judge a mutual fund's performance?

    Evaluate mutual fund performance utilizing resources such as Morningstar; compare the fund with others in its peer group ... Read Answer >>
Trading Center