Annualized Rate of Return

What it is

The annualized (or annual) rate of return measures the average growth of an investment per year over a specified period. It expresses performance as a compounded, time-weighted percentage and is useful for comparing investments held over different lengths of time. Unlike a simple arithmetic average, the annualized return reflects the geometric mean and accounts for compounding.

Key takeaways

• Annualized return shows the compounded average yearly change in an investment’s value.
• It’s calculated as a geometric mean (commonly using the compound annual growth rate, CAGR).
• It’s more informative than a simple return when comparing investments across different time horizons.
• Different measures (money-weighted, time-weighted, Modified Dietz) adjust for cash flows and timing.

How it works

Annualized return converts a multi-year return into an equivalent yearly rate that, when compounded each year, produces the same overall gain or loss. This evens out volatility and makes comparisons meaningful across assets and periods.

Common contexts:
* Stocks, bonds, mutual funds, ETFs, commodities, and many derivatives.
* Retirement accounts (e.g., 401(k)) and portfolios where contributions or withdrawals occur.

Primary formula (CAGR)

CAGR = (Ending Value / Beginning Value)^(1 / Years) − 1

This gives the constant annual growth rate that would produce the observed change in value over the holding period.

Example

An investor buys a stock for $20 and, after five years, sells it for $35. They also received $2 in dividends during the period.
Beginning value = $20
Ending value (including dividends) = $35 + $2 = $37
* Years = 5

CAGR = (37 / 20)^(1/5) − 1 ≈ 0.131 or 13.1% per year

Although the total return over five years is 85% (17/20), the annualized return shows the equivalent yearly compounded rate (13.1%).

Important note: compounding is asymmetric—a 50% loss requires a 100% gain to recover.

Calculating returns for accounts with cash flows (e.g., 401(k))

When contributions or withdrawals occur during the period, adjust for cash flows before annualizing:
1. Compute the adjusted final value by subtracting net contributions made during the period from the final balance (or handle withdrawals as negative contributions).
2. Total return = (Adjusted Final Value / Starting Balance) − 1
3. Convert to an annualized rate (using CAGR or a cash-flow–sensitive method below).

Other return measures

• Time-weighted rate of return (TWRR): Neutralizes the effect of investor cash flows; preferred for evaluating manager performance.
• Money-weighted rate of return (MWRR) / Internal Rate of Return (IRR): Reflects the investor’s actual experience by accounting for timing and size of cash flows.
• Modified Dietz: An approximation to IRR that weights cash flows by the fraction of the period they were invested; useful when exact IRR is impractical.
• Periodic to annual conversion: You can compute monthly or quarterly returns and compound them to an annual rate—but be careful to compound correctly rather than simply multiplying.

Quick ROI refresher

Return on Investment (ROI) = (Final Value − Initial Cost) / Initial Cost
Include fees, commissions, and markups in the cost before calculating percent return. ROI is a simple total-return measure and does not annualize performance.

Interpreting annualized returns

• Use annualized returns to compare investments over different holding periods.
• Check which return measure was used (CAGR, TWRR, MWRR) because results differ when cash flows are significant.
• Marketing materials often quote annualized figures—verify the calculation method and the period used.

Bottom line

Annualized returns convert multi-period results into a consistent yearly rate that accounts for compounding, making them essential for performance comparison and assessment. Choose the appropriate method (CAGR, time-weighted, money-weighted, or Modified Dietz) depending on whether you need to account for investor cash flows or isolate manager performance. If you’re unsure which approach fits your situation, consider consulting a financial professional.