How to Calculate Annualized Return

Understanding your investments’ performance is key to being a successful investor. Annualized return simplifies portfolio performance by showing how much your investments grow yearly, accounting for compounding.

In this article, we’ll explain annualized return, break down the formula, and walk you through an example.

What is an Annualized Return?

An annualized return, or annualized total return as some refer to it, is a calculation that allows an investor to understand how much an investment has earned over a specific period if the return factored in compounding.

Often, funds list the annualized return for specific mutual funds and ETFs to show past performance. However, it’s important to understand that these returns don’t indicate future returns and fail to show investors an investment’s volatility.

For example, let’s look at two different Vanguard mutual funds.

First, the Vanguard ESG U.S. Stock ETF has the following annualized returns:

• 1-year: 24.68%
• 3-years: 7.40%
• 5-years: 14.50%

Now, look at the annualized returns for the Vanguard Dividend Appreciation ETF.

• 1-year: 17.02%
• 3-year: 6.51%
• 5-year: 11.52%

However, these annualized returns don’t tell the whole story. It’s also important to understand the standard deviation, which measures the degree to which the fund has fluctuated from previous returns. The higher the standard deviation, the greater the volatility.

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Standard Deviation for Vanguard ESG U.S. Stock ETF

• 3-year: 18.59%
• 5-year: 19.09%

Standard Deviation for Vanguard Dividend Appreciation ETF

• 3-year: 15.45%
• 5-year: 16.06%

As you can see from the two funds, the Vanguard ESG U.S. Stock ETF offers a greater return for one, three, and five years, but it also carries greater risk.

What is the Annualized Return Formula?

You’ll use the following formula to calculate the annualized return for a specific investment.

Annualized Return =​ (1 + Return) ^ (1 / N) – 1

​In the formula, “n” would represent the number of periods you want to calculate.

While it’s possible to break everything down and calculate the annualized return based on the return for each period, the easiest way is to start with your total return.

You would figure out your total return using the following formula:

(ending value – beginning value) / beginning value

Example of How to Calculate Annualized Return

Let’s look at an example to help you understand how you would calculate annualized returns.

Assume your initial stock purchase three years ago was worth $1,500. You recently sold your position for $3,500. You would start by figuring out your total return on your investment.

($3,500 – $1,500) / $1,500

Total Return = 1.33 or 133%

Now, you can use the total return to determine the annualized return on your three-year stock investment.

(1 + 1.3) ^ (1 / 3) – 1

= 2.3 ^ 0.33

= 1.32 – 1

= 0.32 or 32%

This means that a stock portfolio that started with an initial investment of $1,500 three years ago and which you sold for $3,500 had an annualized return of 32%.

Annualized Return vs Annual Return

When discussing portfolio returns, there is some confusion between annualized returns and annual returns. There are some similarities between the two, but also some significant differences.

The annualized rate of return will calculate the annual return over a period of time. This number is interdependent on all subsequent years because it’s factoring in compounding.

On the flip side, annual returns are a more straightforward way to calculate returns and don’t give investors the whole picture or allow you to compare investment funds. The annual return formula is simple. You will add up the total return of an investment and divide it by the number of years you are analyzing the investment.

Reporting Annualized Return

When calculating the annualized rate of return, the Global Investment Performance Standards (GIPS) established a principle that must always be followed. It states that you can’t report annualized returns if the investment hasn’t existed for a year.

For example, let’s say that a particular investment opened up six months ago, and so far this year, it has returned 7% to investors. Because it hasn’t been available for a year, you couldn’t say it has an annualized rate of return of 14%. The idea behind this principle is that it requires funds to state facts and not predictions about performance.

The Bottom Line

Understanding the annualized returns for your investments is a great way to get the complete picture. Unlike annual return, this way will factor in compounding so you can accurately compare different investment companies and individual funds side-by-side.