Annual Return

The return earned over a period of one year due to activities such as investing

Author: Lay Shang
Lay Shang
Lay Shang
Quantitative finance is my Major. I have a background in data analysis as well as strong financial literacy. In my work I will use software including python, excel, and R studio to help me solve problems.
Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:October 31, 2023

What Is an Annual Return?

Annual return is the return earned over a period of one year due to activities such as investing. This includes any increase in the value of your investments, like stock prices going up, as well as any dividends you receive, and so on.

Generally speaking, when the total capital value at the end of the year is lower than the initial capital value, we consider capital loss and investment return to be negative.

When the sum of capital values at the end of the year is higher than the initial capital value, we consider capital to be profitable and the return on investment to be positive.

This concept is used to determine the growth in the value of financial products such as stocks, funds, and bonds. It is one of the many factors taken into consideration by investors and financial institutions. When investors choose financial products, they focus on annual returns. 

Higher returns are generally more attractive to investors. Companies and financial institutions strive to offer financial products with the highest annual returns to attract more customers and earn commissions.

For example, when people want to assess the stock market, they often look at the annual returns of major stock indexes like the NASDAQ, S&P 500, and Dow Jones. In 2021, these indexes had returns of 21.39%, 26.89%, and 18.73%, respectively. These numbers tell us how well the stock market performed that year, making it easier for investors to analyze their investments.

Investors can also use annual returns to compare different stocks or products over the same period or even across different years. This helps them determine which investments are performing better.

Key Takeaways

  • Annual return is the earnings accumulated over a one-year period from various investments, including changes in share prices and dividends.
  • A positive annual return signifies profitability, while a negative one indicates capital loss. It's a crucial metric for investors to assess the performance of their investments.
  • Annual returns enable investors to compare the performance of different financial products, aiding in decision-making.
  • For longer investment horizons, annualized return, which factors in compounding over multiple years, provides a more comprehensive view of investment performance.
  • While annual returns are valuable, they shouldn't be the sole criterion for judging investments. Other factors and macroeconomic conditions should also be considered.

Annual Return Formula

In general, when we calculate returns over the course of a year, we calculate our return by adding up the returns we made during the year through investments in stocks, funds, derivatives, etc. 

Then, subtract the assets you owned at the beginning of the year from your year-end assets. Finally, to get the return you earned on your investments during the year, divide the number by the value of your assets at the start of the year. 

When comparing multiple products, we may prefer to put the numbers together and compare them directly, in the form of year-end returns. Such numbers can give us a more intuitive picture of that year's revenue. 

Annual Return = [(Final Value of Assets - Beginning Value of Assets)/ Beginning Value of Assets] * 100%

In this case, we can take the assets at the end of the year minus the assets at the beginning of the year, divide the difference by the assets at the beginning of the year, and then figure out the year-end return.

For example, when we compare multiple funds. Their year-end returns may be different due to the differing sizes of the funds. However, when we translate this into year-end returns as a percentage, it becomes clearer which funds are generating the most returns.

Annualized Return

When we need to calculate returns over many years, we use the formula for annualized returns, which combines returns over many years. If we only look at the one-year yield of a product, sometimes it will be too one-sided to understand the yield of a product.

In order to show the return of an investment more objectively, people generally add the return rates of multiple years together to get the overall return rate in a period of time. The time frame can be years or even decades.

If we keep doing what we did before, we just add up the returns over the years and then divide by the number of years included. This would yield an average return over several years. Annualized return is needed if we want to know the overall investment return during this period, so let's factor in compounding.

Annualized Return Formula

There are usually two ways to figure out the annual return here. 

1. We can decide which method to use depending on the information we have. The assumption of the first formula is that when we know the annual rate of return and the number of years we need to calculate.

Annual Return = [{(1 + a1) * (1 + a2) * (1 + a3) * .... (1 + an)}(1/n) - 1] * 100%

In this equation, “a” represents the rate of return and “n” represents the total number of years to be calculated. Plug the corresponding number into the formula to calculate the annualized return over that period of time.

2. This method assumes we know the total value of the investment at the end of the cycle, allowing us to calculate the annualized return by comparing the value of the investment at the end of the cycle to the value of the investment at the beginning of the cycle.

Annual Return = [(Value of the Investment at the End/ Value of the Investment at the beginning)(1/n) - 1] * 100%

This method can be used when we know the value of the investment at the end of the cycle. You plug in the numbers and get an average annual return for the whole period, allowing investors to see earnings more clearly.

Annual Return Examples

Now, let's take a look at a few examples to apply the above formulas. 

Example #1

At the beginning of the year, Company A made foreign investments totaling $30 million. At the end of the year, the assets are now worth 35 million dollars. 

[(3500 - 3000)/ 3000)] * 100% = 16.67%

So, using the first formula, we can calculate that Company A earned an annual return of 16.67% on its foreign investment this year. Using the formula can quickly help us figure out the annual rate of return.

This approach is only for the simplest case and can only describe returns for one year. If we're talking about a longer period of time, we need to use an annualized approach.

Example #2

Bob bought 100 shares of a company the year before last at a price of $3 a share. He received a dividend of $0.50 per share during the three years he held the stock. The stock is now trading at $6 a share. He now wants to know what his return will be in three years’ time. 

In this situation, we can't use what we had before. We need to take compounding into account. Now that we know what the stock is worth at the end, we can start doing the math:

[{(6 * 100) + (0.5 * 3 * 100)}/ (3 * 100)]1/3 - 1 * 100 = 35.72%

Bob ended up with a strong return on his investment. 

As you can see, this method allows investors to calculate their annual returns as quickly as possible.

Example #3

Mike wants to buy shares of a fund. He has his eye on two funds. He wants to invest in one of these two funds. They are not the same size, so Mike is going to calculate their returns over the last three years. 

He downloaded the two funds' returns over the last three years from their websites. 

Fund A rose 15% in the first year, fell 5% in the second, and rose 13% in the third. Fund B increased by 10% in the first year, 5% in the second year, and 10% in the third year. According to the previous formula, we can calculate the returns of the two funds respectively:

Fund A:

[{(1 + 0.15) * (1 + 0.13)}1/3 - 1] * 100% = 7.27%

Fund B:

[{(1 + 0.10) * (1 + 0.05) * (1 + 0.10)}1/3 - 1] * 100% = 8.31%

From these two results, we can quickly see that Fund B did worse than Fund A in two of the last three years. However, the annualized return over three years is higher than fund A. 

Through this formula, we can use compounding and get the most accurate annual rate of return, rather than simply averaging it out. This method can help investors select investment targets. If ordinary investors see only one year of high returns, they may impulsively invest. 

This analytical approach can quickly help investors get the most accurate information, help them think calmly, and analyze the final conclusion.

Annual Return Features

Depending on the characteristics of annual returns, it can be used in different situations. It can help one establish investment goals, compare different investment goals, and so on. Investors use its features to help them profit.

1. Determine the performance of the investment object

When there are doubts about the continued profitability of a current investment, investors can compare past returns to recent ones. This helps determine the trend of the rate of return. 

Analysis can then help investors determine further operational plans.

2. Helps investors set up psychological expectations of returns

By calculating this number, we can clearly understand the annual return of the targeted investment in the past period. This helps investors determine whether they can get satisfactory returns. 

It gives investors a psychological expectation of possible returns, allowing them to choose investments with a forecast of future returns, rather than being ignorant of the risks ahead

Although when one invests, they invest in the future of the asset, having a certain understanding of the past rate of return helps analyze how well the asset generates returns.

3. Compare investment targets

Past returns can help investors conduct a certain degree of analysis when they are faced with many investment choices. Annual returns can be analyzed, not only for a single investment, but also for two or more investments over the same period. 

By doing separate calculations, you can work out the returns for both assets (if comparing two). The resulting annualized rate of return would have an element of compound interest, giving a better picture of returns on different benchmarks. This helps investors compare different assets more easily.

4. Tip: do not let it be the sole criterion

Returns in the past should not be the only metric to judge the quality of an investment. However, the rate of return still can, at least partially, help investors analyze possible future investment returns. 

In some cases, an investment's return may fall through at no fault of its own. For example, when a pandemic comes, global supply chains are affected, hurting all manufacturers' production. 

This may cause a given company's annual returns to fall. 

Maybe government policy changes, leading to the industry's annual rate of return to collectively decline. So, annualized returns should not be the only factor in judging investments.

 We need to consider more indicators and macro aspects to judge the quality of the investment.

Conclusion

Annual return can help judge a target investment. Generally, the stock market is expected to return around 10% annually. However, annualized returns can vary by industry and market. We need to consider a number of factors in our analysis. 

For example, emerging industries may have higher annual returns than some traditional industries, perhaps because the market believes that emerging industries can create more value in the future. 

We need to analyze the data and the market in different situations to come up with answers. Gaining financial and accounting knowledge can help us make better choices when facing numerous investment opportunities.

Use the information that numbers provide to help analyze. It is only one of many indicators and does not play a crucial role. After gaining financial knowledge, we need to combine more indicators to discern the quality of an investment.

Researched and authored by Lay Shang Linkedin

Reviewed and edited by James Fazeli-Sinaki LinkedIn

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