What Is Annual Return? Definition and Example Calculation

What Is an Annual Return?

An annual return is the return that an investment provides over time. It's expressed as a time-weighted annual percentage. Sources of returns can include dividends, returns of capital, and capital appreciation. The rate of annual return is measured against the initial amount of the investment and it represents a geometric mean rather than a simple arithmetic mean.

Understanding Annual Return

An annual return can be calculated for various assets, including stocks, bonds, funds, commodities, and some types of derivatives. It's the standard method for comparing the performance of investments with liquidity. This process is a preferred method, considered to be more accurate than a simple return because it includes adjustments for compounding interest. Different asset classes tend to have different strata of annual returns.

Annual Returns on Stocks

The annual return expresses a stock’s increase in value over a designated period. Information regarding the current price of the stock and the price at which it was purchased is required to calculate it. The purchase price must be adjusted accordingly if any splits have occurred. The simple return percentage is calculated first when the prices are determined, with that figure ultimately being annualized.

The simple return is the current price minus the purchase price, divided by the purchase price.

Example of the Annual Return Calculation

$\begin{aligned} &\text{CAGR} = \left ( \left ( \frac{ \text{Ending Value} }{ \text{Beginning Value } } \right ) ^ \frac{ 1 }{ \text{Years} } \right ) - 1 \\ &\textbf{where:} \\ &\text{CAGR} = \text{compound annual growth rate} \\ &\text{Years} = \text{holding period, in years} \\ \end{aligned}$​CAGR=((Beginning Value Ending Value​)Years1​)−1where:CAGR=compound annual growth rateYears=holding period, in years​

Consider an investor who purchases a stock for $20 on Jan. 1, 2024. The investor then sells the stock on Jan. 1, 2029, for $35 and realizes a $15 profit. The investor also receives a total of $2 in dividends over the five-year holding period. The investor's total return over five years would be $17, or (17/20) 85% of the initial investment.

The annual return required to achieve 85% over five years follows the formula for the compound annual growth rate (CAGR):

$\begin{aligned} &\left ( \left ( \frac { 37 }{ 20 } \right ) ^ \frac{ 1 }{ 5 } \right ) - 1 = 13.1\% \text{ annual return} \\ \end{aligned}$​((2037​)51​)−1=13.1% annual return​

The annualized return varies from the typical average and shows the real gain or loss on an investment, as well as the difficulty in recouping losses. Losing 50% on an initial investment requires a 100% gain the next year to make up the difference. Annualized returns help even out investment results for better comparison because of the sizable difference in gains and losses that can occur.

Annual Returns on a 401(k)

The calculation differs when you're determining the annual return of a 401(k) during a specific year. The total return must first be calculated. The starting value for the time period being examined is needed, along with the final value. Any contributions to the account during the period in question must be subtracted from the final value before performing the calculations.

The adjusted final value is divided by the starting balance after the adjusted final value is determined. Subtract 1 from the result and multiply that amount by 100 to determine the percentage of total return.

Other Return Measures

Other common return measures, which may be an extension of the basic return method, include adjusting for discrete or continuous time periods, which is helpful for more accurate compounding calculations over longer time periods—and in certain financial market applications.

Asset managers commonly use money-weighted and time-weighted rates of return to measure performance or the rate of return on an investment portfolio. While money-weighted rates of return focus on cash flows, the time-weighted rate of return looks at the compound rate of growth of the portfolio.

The Bottom Line

Calculating annual return tells you how much you're earning or losing on a particular investment from year to year. It can be a critical component when you're placing your money somewhere to see it grow, such as in stocks, bonds, or mutual funds. It compares performance with liquidity.

Speak with a professional if you're not sure you're calculating correctly so you can plan your next move.