Annual Return: Meaning, Formula & How to Calculate Annualized Returns?

Investing in mutual funds may be a lucrative endeavour. It's like embarking on a journey to explore new horizons and find hidden gems. However, like any journey, knowing where you're headed and what you can expect to gain from it is important. One of the very reasons many investors choose mutual funds is portfolio diversification, which helps manage risk and returns.

You might have heard a common piece of advice related to diversification, and it makes sense. But how do you know which mutual funds you should select?

One way is to check the expected returns of any mutual fund scheme you're considering investing in. This can help you make informed decisions and avoid unnecessary risks in the long term. Also, remember that the expected returns do not guarantee future returns.

To illustrate why this is so important, let's consider an example. Imagine you have Rs. 10,000 to invest, and you're considering two mutual funds: Fund A and Fund B. Fund A has an expected return of 8% in a year, while Fund B has an expected return of 12% per year. At first glance, Fund B might seem like the obvious choice, but is it?

This is where the concept of annual or annualised returns comes into the picture. Let us help you understand it better.

What is Annualised Returns?

Annualised return measures the average rate of return earned by a mutual fund over a specific period. It takes into account the compounding effect over the specified period. In other words, it calculates the average annual return you would receive if you stay invested in the fund for the selected period.

While average returns can give you a sense of your investment's actual gains or losses, annualised returns can provide a more accurate picture of a mutual fund's performance, particularly over longer periods.

The process of calculating the annualised return of a mutual fund investment uses a geometric average that assumes that the annual return is compounded over the given period. This measure can give you an idea of what you could earn over the time frame.

How to Calculate Annualised Returns?

Calculating the annualised returns on mutual funds is a fairly simple process, and it involves using the following formula:

                         Annualised Return = (– ((latest value/first value)-1^(365/latest date – first date)

You can use this annualised returns formula while evaluating the performance of different mutual funds. This metric also forms the basis of annualised return calculators.

To calculate the annualised return on mutual funds, consider the following example:

If you invested Rs. 10,000 on 1st Jan and in a mutual fund, it grew to Rs. 15,000 after 8 months on 1st August. Using these numbers, the annualised return of the mutual fund would be:

Annualised Return = ((15,000/10,000)-1^(365/212)) = 50%

While annualised return can be a useful metric to evaluate the performance of a mutual fund, it should not be the only factor you need to consider before investing money. In fact, you must consider other factors, such as fees, risks, and market conditions to make informed investment decisions in the Indian mutual fund industry.

Additional Read: What is PB Ratio?

Annualised Return Vs. Average Return

Average return is the arithmetic mean of the mutual funds’ returns over any particular period. To derive the figure, you need to sum the returns and divide it by the number of periods.

On the other hand, annualised return is a geometric average that shows what you would earn over a period if the annual return was compounded over multiple years and provides a standardised measure of performance.

An analogy to understand this concept is to think of a runner who is running a marathon. The runner's average speed is the total distance covered divided by the time taken. However, this does not consider the variations in speed throughout the race. Similarly, average return tells us the mutual fund's return but it does not consider the compounding effect of returns over multiple years.

In contrast, annualised return is like the runner's average speed over the entire marathon. It takes into account the variations in speed throughout the race.

Additional Read: What is PEG Ratio?