Measuring the annualised returns on a particular investment during a period of one year helps investors in making educated and strategic investment decisions. Hence, in other words, annualised return meaning is the geometric average of the earnings of an investment over one year. The annual rate of return formula ascertains the rate of return on the invested principle without accounting for any committed or available 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.
If you are an investor and want to start your investment journey, you may visit the Bajaj Finserv Mutual Fund platform to learn more about mutual funds and SIPs. Feel free to make use of their Lumpsum calculator and SIP calculator to calculate your financial goals better.
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.
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”.
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.
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.
