The sole purpose of an investment is to make money, but too many people approach investments haphazardly without a sound understanding of how their investments perform. Without such knowledge, an investor could be committed to a losing or inferior investment and never even know it. Therefore, it is important to know and understand the two most common investment statistics: annualized and absolute returns.
An absolute return measures an investment’s performance without regard to the amount of time committed. This simple statistic tells you how much you made, and can be expressed as a dollar figure or as a percentage of the original investment. Percentages are generally more useful, because they contain elements of both the original investment and the return in a single figure. As an example, making $1,000 is nice, but if you originally invested a million dollars, that return would not be impressive. If you knew you only made 0.1 percent, you would quickly realize the sub-par return, no matter how much was originally invested or subsequently returned.
Calculating Absolute Returns
The benefit of an absolute return is in the ease of its calculation. Subtracting your original investment from your total return tells you how much you made. As an example, if an original $10,000 investment grew to $12,000 in three years, you would subtract $10,000 from $12,000 to derive a $2,000 absolute return. Calculating the percent return is almost as easy, by dividing the dollar return by the original investment. Continuing with the example, dividing $2,000 by $10,000 gives you an absolute return of 0.2, which is converted into percentage format by multiplying by 100. Thus, your return is 20 percent -- but this does not factor in the three years you were committed to the position.
Although an absolute return is easy to calculate, that statistic isn’t easily compared to other investments with different investment terms. As an example, consider an investment offering 15 percent over 18 months, and another offering 10 percent over 11 months. Because each investment differs in time and return, it is difficult to know which is better. An annualized return solves this problem by expressing the returns in an equivalent term of one year. If you were then asked which annualized return is better, 9.8 percent or 12 percent, it would be easy to select the larger one.
Calculating Annualized Returns
The calculation for an annualized return borrows the compound interest formula to project or reduce the absolute return’s time period to one year. Adding 1 to the absolute return in decimal format converts it into a multiplier. Taking the nth root of that multiplier, where “n” is the amount of time in years of the investment, converts the absolute multiplier to an annualized multiplier. Subtracting 1 then gives you the annualized return. The number of years can be whole numbers or fractions thereof. In the previous comparison, add 1 to the first investment’s 15 percent, or 0.15, to arrive at 1.15. Then take the 1.5th root -- 18 months of the investment, divided by 12 months in a year -- of the resulting 1.15 to get an annualized multiplier of 1.098. Subtracting 1 from that gives you an annualized return of 0.098, or 9.8 percent. In the second investment, take the 0.833rd root -- 10 months of the investment, divided by 12 months in a year -- of 1.10 to get an annualized multiplier of 1.12. Subtracting 1 leaves an annualized return of 0.12, or 12 percent. With that calculation, it’s easy to see that getting 10 percent over 10 months is a better investment than getting 15 percent over 18 months.
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