Annualized return on investment

Meaning of Annualized return on investment

Return on Investment or ROI is a financial ratio that shows the return received from a business investment or a series of investments. It is a measure of how much an investor will get back on his investment. Annualized returns are returns that are adjusted for a period of one year. There are numerous instances when we make an investment for a few years, months, or even for a few days. In such cases, it becomes difficult to compare different types of investment avenues based on their returns because of variations in their gestation periods.

The concept of annualized ROI helps to tackle the above problem. Returns on investment from different investment options made for various lengths of periods can be brought to a common format in the form of annualized ROI. An investor can easily judge which is the best investment option by using the results. Moreover, an investor can opt to find out annualized returns of an investment over many years if he does not want to rely on the results of a single year. In other words, annualized ROI is the Compounded Annual Growth Rate (CAGR) as it takes into account the effect of compounding.

Calculation of annualized return on investment

The formula for calculation of annualized return on investment is:

{(Ending value /Beginning value) ^[1/ {(Ending date – Starting date)/365}]} – 1

Example

Suppose Mr.X buys a stock for US$10 on 1st January 2020 and sells it for US$12 after 200 days.

His regular ROI is: (12-10/10)x 100= 20%

His annualized return will be:

{(12 /10)^ [1/{200/365}]-1

={1.2^[1/.55]}-1

=(1.2^1.82)-1

=36.5% p.a.

Therefore, by calculating the annualized ROI, it becomes easier to choose between two or more investment alternatives with different time frames. It will help in making rational investment decisions with maximum returns.

There are instances where we have annual rates of return for every year of the investment period. Such a situation is typical in cases like mutual funds. Now, if we have to find our annual return from such an investment, we will calculate it as:

Annual return:

{[1+R1]x[1+R2]x[1+R3]…..x[1+Rn]] *[1/n] – 1} x 100

Example:

Suppose Mr.Y has an investment in mutual funds that has given him a return of 15% in 1st year, 10% in the 2nd year, and a negative return of 5% in the current year. He wishes to find out his annual returns from the investment. The calculation for the same will be:

Here, R1- 15%. R2- 10%, R3- -5%

={[1+.15]x[1+.10]x[1-.05]*[1/3] -1} x 100

={[1.15 x 1.10 x 0.95]* [1/3] – 1} x 100

={[1.20*1/3] – 1}x 100

=[1.06-1] x 100

=.06×100

=6%

Therefore, Mr.Y has received an annual return of 6% on his investment.

Annualized Return on Investment

Importance of Annualized Return on Investment

Takes into account the compounding factor

The concept of annualized ROI takes the magic of compounding into consideration. For example, if we have an investment in mutual funds, we receive annual returns based on compounding. Our investment is not independent every year but interdependent. In other words, our investment plus the returns generated in a year will become the basis for the calculation of ROI in the next year.

It is why if we know the annual returns from our mutual fund for three different years, we cannot just take a simple mathematical average to arrive at our annual return each year. This way, the compounding effect will be ignored, resulting in the wrong results.

Thus, this concept helps to find the most profitable investment option out of a bunch of investments. It helps to channelize the scarce economic resources of a business to the best alternative available and maximize profitability.

Accordingly, a business can make crucial decisions. It can be helpful in deciding which products, stocks, or real estate to invest in. Also, the concept can help in making important decisions with regard to production. A company can increase or decrease the production of a product as per its respective ROI. The product with a higher ROI can be prioritized in the production schedule and vice-versa. Similarly, a product with a negative ROI can be discontinued.

Helpful in comparisons

Converting returns on investment into annualized figures helps make strategic, educated, and informed investment decisions in both work and personal finances. It acts as a performance measure. We can quickly compare returns from different investments for different periods and select the best available alternative.

Limitations

Annualized ROI can prove to be misleading in cases of new investment avenues or in times of a turbulent economic environment. For example, a new mutual fund with three-four months of existence may give low returns initially. If we judge the fund based on its annualized returns from the three months, the results can be wrong. The returns might have been less due to the fund being new, and hence, using it for comparison with other funds will be inappropriate.

Similarly, a fund may give low returns in a short phase of time due to bad market conditions or turbulent economic situations. Converting the return from that phase into annualized figures and using it for investments will again prove to be wrong and misleading. So for calculating and before making a proper decision, enough history and data of the proposed fund should be available for analysis.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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