Consolidated Annual Total Return
The annual total return calculates the average amount earned from an investment on a yearly basis. This may be based on the fiscal year or may be over an alternative period lasting 12 months.
It is useful to know the annual total return when the dollar return on investment is known, but the actual percentage is not. It also allows you to compare the returns of investments over different time periods.
For example, suppose you held a stock for a certain number of years and invested in a property for a different number of years. Using the annual total return, you can directly compare the performance of these two investments.
You can compare two mutual funds with a change in value over a number of different years. The annual total return is a good way to compare the success of your investments.
How Does Annual Total Return Work?
Suppose you want to compare the performance of two mutual funds. To do this, you need to know two variables: the return over a specified period and the duration the money was invested.
Here’s the formula:
Annual Total Return = (1 + R1) × (1 + R2) × (1 + R3) × … × (1 + Rn)^(1/N) – 1
In the above equation, “R” is the return, and “N” is the number of years the money was invested.
Suppose you own a mutual fund that had the following annual returns over four years: 7%, 10%, 8%, and 12%. Plugging the numbers into the equation, the result will be:
Annual Total Return = {(1 + 0.07) × (1 + 0.10) × (1 + 0.08) × (1 + 0.12)}^(1/4) – 1 or 1.09232 – 1 = 0.09232 × 100 (to express it as a percentage) = 9.23%.
Thus, the annual total return for the mutual fund is 9.23%. Let’s say you then want to compare this fund’s return with another fund that has different annual returns over two years. In this case, you would repeat the equation and input the new percentages for R and the estimated number of years for N instead of four years.
Annual Total Return vs. Average Annual Return
Investments are often evaluated based on the average annual return instead of the annual total return. You should be aware that these two metrics are not the same.
The average annual return is simply the total return over a time period, divided by the number of periods that have passed. It ignores compounding, while the annual total return takes compounding into account.
The average return is often used to assess a mutual fund’s performance or to compare two or more. If the fund achieved a return of 12% in the first year, lost 20% in the second year, and achieved 15% in the third year, the average annual return over three years would be:
Average Return = (12% + -20% + 15%) / 3 years = 2.33%
The annual total return for the same three-year period will be quite different. Plugging the same numbers into the formula to find the annual total return, the result will be:
Annual Total Return = {(1.12) × (0.80) × (1.15)}^(1/3) – 1 = 0.0100 × 100 ≈ 1.00%
In the year when the investment lost 20%, you have 80% of the balance from the end of the first year. This is why it is multiplied by 0.80. You can see the impact of the loss in the second year on the annual total return compared to the average annual return.
The annual total return takes compounding into account; the 20% loss in the second year negatively affects the positive impact.
Benefits of Annual Total Return
The annual total return, compared to the average return, provides a clearer picture of the investment’s value.
The annual total return gives insight into investment performance, but remember it does not provide any indication of price volatility or fluctuations. When considering metrics, investors tend to place higher value on net profits, or the amount of money that the investment has made or lost over a period of time after fees are deducted.
Taking
Annual Total Return Consideration
The annual total return allows you to compare two different investments over varying time periods. It often provides a clearer picture of the value of the investment, as it takes accumulation into account.
Although this metric gives a preview of the investment’s success, it does not provide any indication of price volatility. Therefore, it should be used alongside other metrics to assess the investment.
Key Conclusions
The annual total return allows you to compare two different investments over varying time periods. It often provides a clearer picture of the value of the investment, as it takes accumulation into account. However, it should be used alongside other metrics to assess the investment, as it does not provide any indication of price volatility.
Source: https://www.thebalancemoney.com/calculate-compound-annual-growth-rate-357621
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