Choosing the right mutual funds requires careful evaluation of expected returns. These returns are typically expressed in two ways: absolute and annualised. The latter, which are often preferred by investors, give a more accurate picture of performance over the long run.
This blog aims to decode this concept, the calculation process, and their importance.
About the metric
Annualised return also called CAGR, i.e., Compounded Annual Growth Rate, shows the average yearly return on an investment, considering the impact of compounding. This helps compare different investments on a common scale.
Say if a mutual fund has a 3% return over six months, this is a short-term gain. The same fund shows an 8% annualised return over three years. It means the investment grew by an average of 8% each year, not just a total of over three years.
Compounding is key. It makes your investment grow faster over time. To give you an idea, consider the ‘Rule of 72.’ This handy shortcut helps estimate when your investment will double. Simply divide 72 by the annual return rate. The result shows the duration needed for your investment to increase twofold.
Accordingly, a 10% annualised return can double your money in about seven years. At the same time, a 2% slight increase to 12% return can double the same in like six years. This is the power of compounding.
The calculation uses a geometric average, assuming annual compounding. This gives a realistic view of a mutual fund’s performance over time. It shows what you could earn yearly if you stay invested for the chosen period.
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Difference Between annualised return and absolute return
Absolute return shows the total percentage change in an investment’s value over a specific period. It simply reflects the overall growth or decline without considering the time aspect.
Yet, CAGR shows how much your investment grows each year on average. Plus, it takes into account the power of compounding. This makes it more useful for comparing investments over varying time frames.
Say, if an investment goes from ₹1 lakh to an additional ₹50k in two years of time, the absolute return is 50%. This shows the total increase over the whole period.
Since it’s about percentage change,
Absolute return = (Present NAV−Initial NAV) /( Initial ) *100
= (1.5 lakh-1 lakh)/ (1 lakh) *100
=50%
However, the annualised return for the same investment would be about 22.47%. This percentage shows the average annual growth rate, considering how the investment compounds each year. How is it calculated? Check the next section.
Absolute return is straightforward and useful for short-term investments. It reports the total gain or loss over a given time period. Annualised return, in comparison, provides a clearer view of long-term performance. It standardised returns to a yearly rate, making comparisons easier and more accurate.
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Annualised rate of return formula & calculation
The formula for calculating the CAGR is
=(((Present NAV / Initial NAV)^ (1 / Number of years))−1)*100
Using the formula for our previous example,
=(((1.5 lakh /1 lakh)^ (1 / 2))−1)*100
≈ 22.47%
This calculation gives an annualised return of approximately 22.47%. The annualised rate of return formula excel is the same, copy the formula and substitute with required numbers to get the desired value.
Let’s take an example considering two mutual funds.
Assume your initial investment in Fund Alpha and Fund Beta is ₹10,000 each for five years.
| Year | Fund Alpha Value | Fund Alpha Absolute Return | FundAlpha Annual Return | FundBeta Value | Fund Beta Return (%) | Fund Beta Annual Return (%) |
| 1 | 12,000 | 20% | – | 11,500 | 15% | – |
| 2 | 14,500 | 45% | – | 13,500 | 35% | – |
| 3 | 13,800 | 38% | – | 16,200 | 62% | – |
| 4 | 15,800 | 58% | – | 17,500 | 75% | – |
| 5 | 16,000 | 60% | CAGR =(((16000/10000)^(0.2))-1)*100= 9.8% | 20,000 | 100% | CAGR =(((20000/10000)^(0.2))-1)*100= 14.9% |
Therefore, Fund Beta has a higher CAGR compared to Fund Alpha over the given time frame. To calculate easily, try any online annualised rate of return calculator.
While the tool is helpful for gauging investment potential, it’s not foolproof. Real returns can vary due to market swings and external factors. The actual outcome might differ from the projected. Keep it in mind when planning your investments.
How is the annualised rate of return different from average return?
An investment’s average return is the numerical average of its returns over a specific time period. Sum up all the returns, divide by the number of periods, and you get the average.
However, the annualised return tells a different story. This measure considers compounding, showing what you’d earn annually if returns were reinvested.
While average return is simple, annualised return is more accurate for long-term insights. It reflects true investment performance, adjusting for compounding effects.
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Bottomline
Understanding annualised return is essential for investors. While useful for projecting potential performance, remember it’s not a guarantee. Market fluctuations can alter actual outcomes.
Use annualised return to compare investments over different time frames, but always stay informed and consider various metrics to make well-rounded decisions.
FAQs
- What is the formula for annualised rate of return?
The formula for the annualised rate of return is simple. You divide the final value of the investment by the initial value. Then, you raise the result to the power of 1 divided by the number of years. Finally, subtract 1 and multiply by 100. Or (((Present NAV / Initial NAV)^ (1 / Number of years))−1)*100. This gives you the percentage growth per year.
- What does a 5 year annualised return mean?
An annualised rate for the period of five years reveals the rate of compounded growth an investor earns from an investment every year within the five-year span. It includes the effect of accumulation. Say, if the return is indicative of 7%, then the investment increases by that on average per year. It is useful in determining the long term efficiency of an investment, as compared to the more short term-oriented rate of return.
- Is annualised return the same as CAGR?
Yes, indeed, the annualised return is one and the same with CAGR. CAGR simply means Compound Annual Growth Rate. This is one which demonstrates how much an investment increases annually including the matter of compounding. It is among the ways of determining the returns of an investment that is made over a period of time. In this sense, they mean the same thing.
- Is 10% annualised return good?
A 10% annualised return can be considered good. It depends on the investment and market conditions. For some, it’s a solid growth rate. For others, it might be just okay. Compare it to other investments and your financial goals. Always consider the risk involved. It’s not just about the return percentage.
- What is the difference between XIRR and annualised return?
XIRR or extended internal rate of return and annualised return are different. XIRR calculates returns when there are multiple investments at different times. It’s useful for irregular cash flows. Annualised return, or CAGR, shows average yearly growth with regular investments. XIRR gives a more detailed view if investments are not consistent. Both help understand investment performance.
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