What is an annualised return?

Investors are often overburdened by a variety of financial metrics when assessing the performance of their investments. One such crucial measure is annualised return. This metric goes beyond the surface-level returns and provides a more comprehensive view of an investment's performance over time. In this article, we will understand what annualised return is, how it is calculated, how it differs from absolute return, and its significance.

Understanding Annualised Return

Annualised return is a measure used to express the average rate of return on an investment over a specified period, typically calculated on an annual basis. It offers a standardised way to assess and compare the performance of investments with varying timeframes.

While the absolute return provides the actual gain or loss on an investment over a specific period, the annualised return considers the compounding effect over time, offering a more accurate representation of the investment's performance.

How is Annualised Return Calculated?

Annualised return formula:

((1 + Absolute Rate of Return) ^ (365/number of days)) – 1

For example, if the NAV increases from Rs. 40 to Rs. 50 in 7 months, the Absolute Return is 25% i.e., 0.25.

Then annualised return can be calculated as:

((1 + 0.25) ^ (365/210)) – 1

i.e., 47.38%

However, this method holds good if the period of holding is exactly one year.

Absolute Return vs Annualised Return

Absolute return

Absolute return, commonly referred to as point-to-point returns, represent the straightforward returns on the initial investment. This calculation involves the starting value (NAV) and the concluding NAV (current NAV). The duration of holding the fund is not a critical factor in this method. Typically applied to periods of less than one year, absolute returns provide a simple measure of investment performance.

The formula for absolute return:

Absolute Return = ((Present NAV – Initial NAV)/ Initial NAV) *100

Absolute return provides a simple measure of the total percentage increase or decrease in the investment value. Whereas, annualised return, as discussed earlier, considers the compounding effect over time. It offers a more nuanced perspective on investment performance, especially when comparing investments with different holding periods.

Conclusion

In the complex world of investments, annualised return emerges as a powerful metric that transcends the simplicity of absolute return. While absolute return offers a snapshot of the actual gain or loss, Annualised return brings time into the equation, offering investors a more comprehensive and standardised measure of performance.

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