Do you want to invest and grow your money to enjoy the golden years of your life? If so, you cannot overlook the importance of investment! But here’s the catch! When it comes to measuring investment returns, absolute return and annual return are two methods used for making informed investment decisions and reaching your financial goals.
The method you use to calculate your returns depends on how long you’ve held the investment. Let’s say your investment period is less than a year; you’ll typically use the absolute return method. On the other hand, if your investment lasts more than a year, you’ll likely use the annualized return method.
In this post, we’ll explain both absolute and annual returns and understand their meaning, formula, and how to calculate them.
What is an Absolute Return?
An absolute return is the total return generated from an investment, expressed as a percentage. It gives you a simple and hassle-free way to see how much your initial investment has grown over time. The calculation of absolute return focuses solely on two key figures: the initial investment amount and the final value of that investment at maturity. Thus, it means that absolute return does not take into account the length of time the investment was held.
For example, if an Asset Management Company (AMC) claims that one of its funds has achieved an absolute return of 10%, it doesn’t specify whether that return was realized over a few months or several years. Because of this characteristic, absolute returns are particularly useful for investments held for less than a year.
What is the Absolute Return Formula?
The formula for calculating absolute returns is pretty simple:
Absolute Return = ((Selling Price – Purchase Price) / Purchase Price) * 100
Let’s break this down with an example. Imagine Mr Rajeev Shekhawat, who works in an MNC in New Delhi, purchased 100 units of the ABC Mutual Fund Scheme at a Net Asset Value (NAV) of Rs. 10 per unit. Later, he sold those units at an NAV of Rs. 15 per unit. To calculate his absolute return, we can follow these steps:
Calculate the Profit Per Unit:
Selling Price – Purchase Price = Rs. 15 – Rs. 10 = Rs. 5 profit per unit.
(Profit / Purchase price) X 100 = (Rs.5 / Rs. 10) X 100
Which ultimately equals to 50%
In this case, Mr Shekhawat earned an absolute return of 50% on his investment. This calculation helps him understand the overall growth of his investment in percentage terms.
What is an annualized return?
Annualized return refers to the average annual rate of return on an investment, expressed as a percentage. This measure accounts for the effects of compounding, which means it calculates the compound annual growth rate (CAGR) of an investment over multiple years. With smooth fluctuations in returns across different years, annualized return provides a clearer picture of how an investment has performed over time.
It is no secret that this metric is particularly useful for comparing investments with varying returns across different periods, which may allow investors to evaluate which investments have performed better on an annual basis. Furthermore, a long-term CAGR helps investors understand an investment’s future growth potential, as it minimizes the influence of short-term market volatility and shocks. In essence, the annualized return offers a consistent framework for assessing the success of investments over time, which makes it a valuable tool for informed decision-making.
What is the Formula to Calculate the Annualized Returns?
To calculate annualized returns, you can use one of the following formulas:
Annualized return is equal to ((1 + Absolute Rate of Return) ^ (365/no. Of days)) – 1
OR
Annualized return is equal to ((1 + Absolute Rate of Return) ^ (1/no. Of years)) – 1
These formulas allow you to convert the total returns on your investment into an average annual return, providing a clearer perspective on performance over time.
For example, when you see the returns listed for three-year, five-year, or ten-year mutual fund schemes on various Asset Management Company (AMC) websites or financial platforms, these figures represent annualized returns.
Absolute Return vs Annual Return: Key Differences
Let’s take a look into the key differences between absolute return and annual return based on the following parameters.
| Particulars | Absolute Return | Annualized Return |
| Definition | Absolute Return refers to the total percentage change in the value of an investment over a specific period without considering the effects of compounding. | Annualized Return, on the other hand, represents the average rate of return per year over a specific period while accounting for the effects of compounding. |
| Calculation | Speaking of the absolute return calculation formula, simply use the following:
((Present NAV – Initial NAV)/ Initial NAV) × 100 | On the flip side, the calculation for annualized returns is
((Present NAV/ Initial NAV) ^ (1/no. Of years)) – 1 |
| Accuracy | Absolute return is generally less accurate than annualized return because it does not take compounding into account. As a result, it may not fully reflect an investment’s actual growth over time. | Annualized Return, on the contrary, is considered more accurate because it includes the impact of compounding, giving a better understanding of how the investment performs on an annual basis. |
| Simplicity | Absolute Return is simpler and easier to understand, making it accessible for beginners or those unfamiliar with investment concepts. It simply shows how much value has changed. | Annualized Returns are more complex to grasp because they involve calculations that consider compounding, which might be challenging for some investors to understand. |
| Usefulness | Absolute Return can be valuable for comparing the performance of different investments over various periods. It helps investors see how much value has changed. | On the other side, an annualized Return is particularly useful for forecasting future returns. By providing an average annual rate, it can help investors estimate potential growth over longer investment horizons. |
Frequently Asked Questions
Listed below are the frequently asked questions related to the absolute return and annual return.
To convert absolute return to CAGR, you need to calculate the compounded annual growth rate (CAGR) based on the investment’s initial and final values.
Yes, CAGR and annual return mean the same thing. Both terms measure how much an investment has grown from the beginning to the end over a specific time period.
The formula to calculate the Annualized Return (CAGR) from the Absolute Return is as follows:
Annualized Return (CAGR) = [(1 + Absolute Return)^ (1 / Number of Years)] – 1
Yes, annualized return and CAGR (Compound Annual Growth Rate) are the same. Both show the average annual growth rate of an investment over a specific period while considering compounding effects.
A 5-year annualized return, or 5-year CAGR, is the average annual growth rate of an investment over five years, taking into account the effects of compounding.
