Everything You Need To Know About Annualized Return
You should invest wisely by making the right financial decisions. Understanding the total annualized return on your investments is a key factor. The total annualized return indicates an investment’s average compounded returns (or loss) over a 12-month period.
Take any investment products – equities, bonds, p2p investments, real estate, etc. Or even for businesses. You can calculate these returns if you have the correct numbers available with you. The higher the annualized return on your investments, the better is the investment opportunity.
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Let’s delve further into the world of finance where annualized returns is a commonly used term:
What Are Total Annualized Returns?
An investment’s yield over a given time-frame is referred to as the “annualized return.” It represents the percentage rise or decrease in the investment’s value throughout that time on an annual basis. Returns on your investments can be expressed either as absolute or annualized returns. Although, annualized returns or CAGR (Compounded Annual Growth Rate), is the most widely used measure.
Returns are at the core of financial growth. Returns on any investment are typically provided for a defined time-frame, say, past one-year or five-years and so on.
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Absolute Returns are the % times your investment grew irrespective of the time frame. Say your investment of ₹100,000/- is worth ₹150,000/- now, the absolute returns come out to be 50%. The measure is commonly used by financial experts to get an understanding of the times their money grew over. Technically, MoIC or Multiple on Invested Capital is the term used and in our case above, the MoIC comes out to be 1.5x.
On the other hand,
two variables come into play when we talk about CAGR. The time-frame and the annualized return. In our example above, if the time taken to reach the ₹150,000/- mark is 5 years, then our CAGR comes out to be 8.45% on an annual basis. To put it into perspective,
- 8.45% on ₹100,000/- for first year generates 108,450/-
- Since your investments continue for the second year as well, you get 8.45% on ₹108,450/- in the second year. This takes you close to ₹117,614/-
- Similarly in the third, fourth and fifth years, your investment grows at a constant 8.45% consecutively giving you ₹127,550/-, ₹138,330/- leading up to ₹150,000/- in the final year.
So next time someone says they can make your money grow to 20,000 from 10,000, the return on investment will depend on the time-frame too. If it’s 10 years, the CAGR comes out to just 7.18%. But if it’s 6, that’s close to 12% CAGR which is one of the best ROI returns you can get in any investment opportunity.
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Albert Einstein didn’t just say for fun, “the world’s eighth wonder is compounded interest.” Your finances can benefit significantly from compounding at 10 – 12% p.a*. CAGR, you can easily double the amount invested in close to 6 years!
How can you calculate Annualized Returns?
Say you wish to assess the effectiveness of two investment products side by side. You need to know two factors: the return during a specific period and the time the investment was held.
Consider that you own a mutual fund that grew from ₹100,000/- to ₹250,000/- in 15 years. There are three ways you can calculate your CAGR:
- The manual way to do so is (FV/PV)^1/t – 1. Replacing the formula with values, (250000/100000)^(1/15) – 1. That comes out to a CAGR of just 6.30%.
- Another way is to use Excel functions XIRR or IRR.
- The third and the most simple way is to make use of online CAGR calculators where you just have to put in the values and you get your CAGR or future value based on a projected CAGR. Check out our ‘Returns Calculator’ here.
Similarly, you can calculate CAGRs for various investment products and then take your decision which ones are safe investments with high returns in India for you to take into consideration.
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Absolute Return vs Annualized Return
Absolute Return
The direct returns on initial investment are computed using absolute returns, commonly referred to as point-to-point returns. As previously mentioned, absolute returns are used by finance professionals to get a sense of MoIC. However, absolute returns are also helpful to understand the prospects of investments in shorter durations. Say, the tenure of your investment is just 6 months. In that case, annualized returns won’t make sense and it’s best to stick to absolute returns in such cases.
So we can say that in a way, absolute vs annualized returns both make sense in their own different ways. Keep in mind that annualized returns by default factors in the compounding effect from your investments.
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The Benefit of Annualized Total Return and its Limitations
Comparing the annualized total return to the average return can frequently provide a clearer picture of the investment’s value.
You can get a sneak peek at investment performance using annualized total return, but keep in mind that it doesn’t consider volatility or price swings that occur in between. There are various investment products, for instance equities and real estate where you can generate good returns over a longer term. While the historical picture (CAGR) can put you into a world of your dreams, mind well that such investment options are highly volatile. Everyone is aware about the wild price swings in the equity markets which is something that CAGR cannot capture.
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So although CAGR is an important measure to understand, you also have to consider various other aspects such as your risk appetite, the time that you want to stay invested, and your long-term goal for such investments. If you cannot handle short-term losses in your investments, it’s recommended that you consider other new-age non-market linked investment options such as P2P lending.
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*P2P investment is subject to risks. And investment decisions taken by a lender on the basis of this information are at the discretion of the lender, and LenDenClub does not guarantee that the loan amount will be recovered from the borrower.
