Definition: An annualized total return is the average of each investment’s result during a given period.
The annualized total return is used to calculate the annual return on equity for any investment. Financial planners often use it to help determine if an investment will earn extra returns over time, provided it’s taken in the right amount at the right time.
The annualized total return is the annual return that an investor would earn on an investment in a particular stock or bond market, based on the price that the stock or bond was selling at the time it was bought. It represents the total return that an investor could potentially earn, given today’s prices, on their investment in the stock or bond market. Financial analysts use the ATR to measure and analyze investment performance. It is one of the main fundamental components of an investment portfolio.
The goal of the Annualized Total Return is to capture the total gain or loss that investors accrue over time due to the changes in the stock or bond markets plus any fees and taxes that result from those changes; it is not necessarily a measure of actual profit or loss for any particular investment.
Using only two variables, you can calculate the annualized total return of any investment. If the investment is held for a year and returns are calculated for each full year that the investment is held, the annualized total return will be the average of the two annual returns.
The formula for calculating annualized total return is as follows
[(1 + R/2) ÷ (1 – R)) / (1 – t)
where R is the annual return on investment, t is the time horizon, and ÷ is the risk premium (also known as the discount rate).
Investors generally pay a premium to invest in less predictable assets like stocks and bonds because they assume future returns will be higher.
There are two ways to calculate the annualized total return for an investment. The first is to add up all the profits earned during the period and then divide them by the total amount invested. For example, if you sold $10,000 worth of food at a 25% discount for the year, your annualized total return would be ($2,250 + $500 =) $3,750. Multiplying by 12 gives you the annualized return on food.
The Annualized Total Return allows you to calculate the gains over time that accrue to your account from a particular investment, whether stocks or bonds. It gives you the chance to profit more than just once every year. In contrast, the Average Return does not provide this benefit because it does not account for compounding effects. As a result, the Average Return could give you an unexpectedly high return for money invested modestly over time, whereas the Annualized Total Return could underestimate your actual profit.
The idea behind an annualized total return is to take advantage of income opportunities that are subject to change – for example, stock options that become worthless after a year’s worth of dividends or a gain that is taxed at a different rate year than usual because of inflation. By avoiding losses that might suddenly appear, you protect yourself against dramatically changing market conditions while maximizing your potential gains.