What is Annual Return?
The annual return is the income generated on an investment during a year as a percentage of the capital invested and is calculated by way of the geometric average. This return provides details about the compounded return earned yearly and is used to compare the returns provided by various investments like stocks, bonds, derivatives, mutual funds etc.
How to Calculate Annual Return?
Here, years mean the number of years for which an investment is held. The term ending value means the value of the investment at the end of the period for which return is calculated, including the value of any other return earned on such investment, such as dividend income. And, beginning value means the value of the investment at the beginning of the period. Thus, to calculate the annual return, ending value, beginning value, and years of holding are required.
Example
Suppose a stock is purchased by a person on 1st Jan 2001for $30. The stock is sold on 31st Dec 2005 for $ 46. Also, apart from the sales proceed, the investor has received a dividend on the stock of an amount equal to $ 4 during the holding of the stock. Let us see how we can calculate the annual return of the stock in this case.
Solution:
Annual Return = ( 50 / 30)^ 1/5 – 1 = 10.76%
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Difference Between Annual Return and Absolute Return
Absolute return in respect of an investment means the income earned by that investment over a particular period. Thus, it refers to the increase or decrease in the value of the investment for a given period, expressed in percentage. The absolute return does not compare the return of a particular investment with any benchmark or criterion. It is also termed a total return and reflects the overall profit or loss obtained on the investment without considering any other factor.
On the other hand, It is the average returns earned by an investment during a particular year, i.e., annually. Thus, the same provides the returns that a specific investment provides in a year, calculated by geometric average. The yearly return of one investment can be compared with that of another to determine which of them is performing better.
Advantages
- It is an indicator of the compounded returns provided by an investment annually.
- The annual return of an investment can be compared with other investors to determine the performance of the investment as compared to another one.
- It helps an investor to decide whether it is profitable to invest in a particular asset or not.
- The yearly return in one period can be compared with the return of the next period to determine whether the returns are increasing or declining.
Disadvantages
The only limitation attached to the annual return is that it is not the only deciding factor of the performance of an investment, and other factors shall also be considered before an investment decision is taken. For example, the return of a particular stock may be declining because the entire industry is suffering due to a policy decision taken by the government.
Conclusion
The annual return is an essential factor in determining the performance of a particular investment. However, one shall also not ignore the other factors which may impact the performance of the said investment.
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This article has been a guide to what is Annual Return and its meaning. Here we discuss formula to calculate annual return along with an example, advantages and disadvantages. You may learn more about financing from the following articles –
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