Annual Return: Definition, Calculation, and Application in Investments
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Summary:
An annual return represents an investment’s compounded performance over time, expressed as a time-weighted annual percentage. It factors in dividends, capital returns, and appreciation, providing a geometric mean rather than a simple arithmetic mean.
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Understanding the annual return
An annual return measures an investment’s average yearly increase during a specific period. Calculated as a geometric average, it showcases how compounding affects the annual return. This metric is valuable for assessing an investment’s performance over time and comparing different investments.
Annual return and diverse assets
The calculation of the annual return extends across various asset classes like stocks, bonds, funds, commodities, and specific derivatives. This method offers a reliable means of comparing liquidity-based investment performance. Different asset classes typically exhibit varying levels of annual returns.
Annual returns on stocks
Also termed an annualized return, it reflects a stock’s value increase over a specified period. To compute it, knowledge of the stock’s current and purchase prices is necessary, adjusted for any stock splits. This return starts with a simple percentage return, eventually being annualized.
Calculating the annual return: an example
Consider an investor who purchases a stock for $20 on January 1, 2024, sells it for $35 on January 1, 2029, and realizes a $15 profit and $2 in dividends over five years. This totals a $17 return, representing 85% of the initial investment. Using the compound annual growth rate (CAGR) formula, the annualized return equates to 13.1% over five years.
Annual returns on a 401(k)
The process of determining the annual return for a 401(k) in a specific year differs. It involves calculating the total return by factoring in contributions made during the period. Adjusting the starting and final values and subtracting contributions are key steps in this computation.
Other methods of calculating the annual return
The modified Dietz formula considers cash flows and compound returns over each period. Alternative methods include calculating returns monthly and then multiplying by 12 for the annual rate. Online calculators are available for ease of computation.
Calculating the overall return on investment
For calculating the overall return on an investment, subtract the initial cost from its final value, divide by the total investment cost (including fees), and multiply by 100 to derive the percentage.
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