Annualised Return

Annualised return, also known as annual return or annualised total return, represents the geometric average of an investment’s yearly earnings. It calculates the return rate on the invested principal, excluding any unutilised cash or funds already committed.
How to calculate annualised return
3 min
11-December-2024

Annualised return, also referred to as annual return or annualised total return, represents the geometric average of an investment's earnings over a year. This calculation reflects the rate of return on the principal amount invested, excluding any unutilised or allocated cash.

The annual rate of return on mutual funds, similarly shows the investor what he would have earned had the annual return were compounded over a certain time period. However, it needs to be noted that this calculation does not show the investor any negative changes or potential fluctuations in price or the investment’s volatility.

Since analysing a particular investment's rate of return in a single year is not the best gauge of its value always, several investors may calculate an investment's annualised returns over several years. This is possible by calculating the return rate each year or through the grouping of longer time periods when calculating the investment’s annualized return. By making use of the information derived from the annual rate of return formula, the investor can determine the effectiveness of his investment by making a comparison of his returns on similar investments.

What is annualised return?

Annualised returns are also called the geometric average, and is the annual return rate on an investment that analyses its net loss or gain within a specified time period after taking the concept of compounding into consideration. The calculation can benefit an investor since it shows the annual return rate’s interdependency on the return rates of previous years. Moreover, it also provides a clearer picture of the performances of several stocks which were bought and sold over multiple time periods in the past and aids in taking prudent investment-related decisions.

Formula of annualised returns

Annualised Return = (1 + Return) ^ (1 / N) - 1, where N is the total number of periods taken into consideration for measurement.

How to calculate Annualised Returns?

For accurate calculation of an annualised return, initially, one has to work out the investment’s overall return. The basic formula for calculating overall return is the end value – initial or beginning value divided by the beginning value, which is the portfolio’s worth when the investment was made. The end value is the portfolio’s worth at the period’s end on which the calculation is done.

Once the overall return is worked out, the annualised return can be subsequently calculated. In the annualised returns formula, the figure "1" divided by "N" represents the unit being measured, say, one year. Similarly, figure 365 may be used instead of 1 for calculating the investment’s daily return.

The "N" contained in the formula is the total number of periods being measured. For instance, if an investment’s annualised returns are calculated over a five-year period, figure 5 can be used as N.

Hence, the annualised return calculation would be:

(1 + 2.5) ^ 1/5 - 1 = 0.28

Thus, the investment’s annualised returns would amount to 28% over five years.

Calculation of Mutual Funds Annual Return

The annualised returns on mutual funds are calculated on the basis of the Compound Annual Growth Rate (CAGR). The process involves considering the investment’s initial or beginning value, its end or final value, and the investment’s time period in years.

The formula for calculating the CAGR is CAGR=(PVFV)n1

​Once the CAGR is calculated, it has to be multiplied by 100 to be represented as a percentage.

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Example of calculating annualised return

To better understand the calculation of annualised return, let’s study a hypothetical example:

Say you start with an investment of Rs. 2,000. After 5 years, it grows to Rs. 5,000. Now, the first thing you calculate is the “total return”, which shows how much your investment has grown in total.

The formula for total return is:

Total Return = (Ending value - Beginning value)/(Beginning value) x 100

Upon plugging in the numbers, we get:

Total Return = (Rs.5,000 - Rs.2,000)/(Rs.2,000) x 100 = 150%

So, your total return is 1.5 or 150%. Now, after calculating the total return, you want to find out what this total return would be if it were spread evenly over each of the 5 years. This represents the concept of “annualised return”, which is similar to finding an average yearly return that would give you the same overall growth.

The formula for annualised return is:

Annualised return = (1 + Total return)^(1/N) - 1

where:

  • “Total Return” is 1.5 or 150%
  • “N” is the number of years (in this case, 5 years)

Again, we will plug in the numbers:

Annualised return = (1 + 1.5)^(1/5) - 1

Hence, we can observe that your average annual return (or annualised return) is 0.2 or 20%. This means if your investment had grown at a steady rate each year, it would have increased by 20% per annum to reach Rs. 5,000 from Rs. 2,000 in 5 years.

Also read: What is a Hindu Undivided Family

Annualised return in the context of taxes and inflation

When calculating the returns from an investment, it is important to consider the effects of taxes and inflation. For those unaware, taxes reduce the actual money you keep from your returns, while inflation reduces the purchasing power of your money over time. Hence, while determining annualised returns, you must focus on these factors to get a clearer picture of your true investment performance. Let’s study this in detail:

Tax-adjusted annualised return

A tax-adjusted annualised return shows how much you actually earn from an investment after accounting for taxes. Be aware that different investments, like stocks and bonds, are taxed at different rates.

For example, after the latest changes proposed by the Union Budget 2024, long-term capital gains on equity investments held for more than 12 months are taxed at 12.5% (exempt up to Rs. 1.25 lakhs), while LTCG from bonds is taxed at investor’s regular income tax rate (without any indexation benefit).

Hence, by adjusting for these taxes, you can understand how much you are actually earning after paying taxes (often known as post-tax returns).

Inflation-adjusted annualised return

Inflation-adjusted annualised return is also known as the “real rate of return”. It measures how much your investment actually grows in terms of purchasing power. Be aware that inflation reduces the value of money over time. This means that even if your investment grows, it might not buy as much in the future as it does today.

For example, if your investment grows by 8% in a year but inflation is 6%, your real return is only 2%. This adjustment helps you understand how much you are truly gaining after considering the rising cost of goods and services. By focusing on the inflation-adjusted return, you can better judge whether your investments are helping you maintain or grow your wealth in “real terms”.

Also read: What is direct tax code

Applications of annualised return

Annualised return helps investors evaluate how well their investments are performing over time. Standardising returns across different periods makes it easier to compare various investment options and assess risk. Also, it aids in accurate planning for future financial goals, such as retirement or education savings. For a better understanding, let’s study the various applications of annualised returns:

Performance evaluation

Annualised return simplifies the process of comparing different investments. It shows how much each investment grows annually, regardless of the investment period. This makes it easier to identify the best-performing assets, whether they’ve been held for 3 years or 10 years.

Additionally, you can assess performance through “benchmarking”, which involves comparing the annualised return of your investments against market indices like the Nifty 50 or Sensex. This helps you assess whether your investments are performing better or underperforming than the overall market. It must be noted that if your annualised return falls short of the benchmark, it signals a need to adjust your strategy.

Hence, by regularly using annualised returns for both comparison and benchmarking, you can optimise your portfolio and ensure it consistently performs well.

Portfolio construction

When constructing a portfolio, balancing risk and return is important. By using annualised returns, you can understand the reward of an investment relative to its risk. This understanding can significantly guide your asset allocation decisions.

It is worth mentioning that most high-risk investments, like stocks, offer higher annualised returns but also come with greater volatility. On the other hand, lower-risk assets like bonds provide more stability but generate lower returns.

Therefore, by analysing these returns, you can assess whether the expected gains justify the risks. This information also helps you determine the right mix of assets based on your financial goals, risk tolerance, and time horizon.

Financial planning

Be aware that financial planning relies heavily on understanding annualised returns to achieve various goals, such as retirement, education savings, and other financial aspirations. By knowing the annualised return of your investments, you can better project future growth. Also, it allows you to determine how much to save and invest to meet your goals.

For example, when it comes to retirement planning, an analysis of annualised returns suggests adjusting savings or investments to ensure financial security. Education savings means evaluating whether your current plan will cover future education costs. Similarly, for goal-based investing, like investing to purchase a home, it shows how your investments will grow over time to ensure you are saving enough to reach your goal within your planned duration.

Limitations of annualised return

Annualised return is a powerful technique for evaluating the performance of investments. But, it has certain limitations that investors should be aware of. Commonly, these include assumptions about constant performance, the impact of volatility, and potential biases from the performance period chosen. Let’s study them in detail:

Assumptions and simplifications

Annualised return assumes that an investment’s performance is consistent over the entire period, which is rarely the case in reality. It is worth mentioning that investments often fluctuate in value due to market conditions, and these ups and downs are not reflected in the annualised return.

Additionally, annualised returns do not consider factors like reinvestment of dividends or interest or any additional contributions or withdrawals you might make. This gives a misleading picture of your investment’s true performance, as it doesn’t account for these real-world changes that can significantly impact your overall return.

Impact of volatility

Annualised return also doesn’t capture the volatility of an investment. It is possible two investments might have the same annualised return, but if one is highly volatile and the other is stable, they carry very different levels of risk.

Numerous studies have shown that high volatility leads to a more stressful investment experience and might not be suitable for investors with lower risk tolerance. Thus, relying solely on annualised returns can hide the true risk of an investment. This makes it important to consider other factors like “volatility” when evaluating investments.

Performance period bias

The period for which you calculate the annualised return greatly influences the result. Sometimes, it can even lead to biased conclusions. For example, say you choose a period that includes a market boom. In this case, the annualised return might look unusually high and give the impression that the investment is performing better than it usually would. On the other hand, if the period includes a downturn, the return might seem lower than expected.

Hence, to accurately assess an investment's performance, you should carefully select different periods and review various time frames. By doing this, you avoid biases that might result from focusing on just one period, whether it’s a period of strong growth or decline.

Also read: Different types of investments

Key takeaways

  • Annualised return is the geometric average return on an investment over a year, factoring in compounding.
  • The formula for annualised return is (1 + Return) ^ (1 / N) - 1`, where N is the number of periods.
  • Annualised returns in mutual funds are calculated using the Compound Annual Growth Rate (CAGR).
  • It helps investors compare the performance of different investments over varying periods, aiding in strategic decision-making.
  • Annualised returns assume consistent performance, don’t account for volatility, and can be biased by the selected time period.

Conclusion

Annualised returns reflect the average annual growth rate of an investment over a period. By understanding the concept of annualised returns, you can better evaluate the performance of an investment and pick the right option based on your financial goals and risk appetite. Moreover, they are helpful for financial planning, whether it's for retirement, education savings, or specific goals like buying a home. By analysing annualised returns, investors can compare different investment options and make strategic choices.

However, this measure has its limitations. It assumes consistent performance of investments (which is false) and does not account for volatility. Also, it can be influenced by the chosen performance period. Hence, to get a clearer picture, investors must consider these factors along with tax and inflation impacts.

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Frequently asked questions

How do you calculate Annualised return on mutual funds?
The annualised returns on mutual funds is calculated on the basis of average annual returns over a predetermined period, which is more than one year typically for deriving a standardised performance measure. The fund’s historical Net Asset Value is collected for its initial and end dates, followed by the calculation of total return, which is end NAV minus initial NAV plus distributions or capital gains or dividends received during the said investment period. The annualised return is finally calculated using the formula Annualized Return=(1+Total Return)Number of Years1-1

What is a good annual rate of return for a mutual fund?
A good annual rate of return for any mutual fund varies on certain factors like the fund's risk level, investment strategy, and overall market situation. Historically, however, annual yields from mutual funds have been between 5% and 10% on average, even though this could have been lower or higher depending on a specific fund and its examined time period.

What is 3 year annualised return?

A 3-year annualised return represents the average yearly return of an investment over a three-year period. For instance, if a fund delivers a total return of 30% over three years, its annualised return would be 10% per year.

What does 10 year annualized return mean?
A 10-year annualised return denotes the average annual return rate of an investment during a 10-year period, and provides investors with an indication of their investment performed on an annualised basis during the long term.

What is a 5 year Annualised return?
A 5-year annualised return is a measure of the yearly average return on an investment that it has generated during the last three years and is denoted in percentage terms.

What is the formula for annualised return?
The formula for calculating the annualised return is as follows: Annualized Return=(Ending Value−Beginning Value)× number of Years ×100%

Why is the annualised total return important for investors?

The annualised total return shows how much an investment grows on average each year. This measure factors in the effects of “compounding” and allows investors to compare different investments, even if they were held for different lengths of time.

This way, annualised total return provides a more accurate view of how an investment has grown each year on average. Also, it gives a better sense of an investment’s performance compared to looking at total returns or short-term data. 

What is the difference between annualised total return and average return?

The “average return” is a simple calculation of total returns divided by the number of periods. It does not consider compounding. On the other hand, the “annualised total return” shows the average annual growth rate, including the effects of compounding. This makes the annualised return a more accurate measure of how an investment truly performs over time.

How does annualised total return differ from the compound annual growth rate (CAGR)?

Both annualised total return and CAGR measure the average annual return after accounting for compounding. The key difference is that CAGR usually compares only the beginning and ending values over a set period, while annualised total return uses multiple years of data.

Also, CAGR gives a simplified view of an investment's average yearly growth rate by “smoothing out fluctuations”. Conversely, annualised total return accounts for fluctuations in performance over time.

Why can't an investment with less than a year of performance data report an annualised total return?

An investment needs at least one year of performance data to report an annualised total return accurately. This is because annualised returns are meant to show the average annual growth rate. Without a full year’s data, it’s difficult to accurately predict how the investment will perform over a year. Also, shorter periods usually do not provide a reliable estimate of long-term performance.

What is the purpose of annualising returns over periods shorter than a year?

By annualising returns for periods shorter than a year, investors can estimate how the investment will perform over a full year if the current rate of return continues. This provides a way to compare short-term returns on an annual basis. However, it is worth mentioning that annualised return is just an approximation. Investors must not consider it as a precise prediction of future performance.

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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.