Annualised Return: What Does It Mean?
You may have heard the term Annualised Return come up in your research into property investment. And you’re not alone in wondering what on Earth it is.
With that in mind, we thought it’d be a good idea to give you a bit of an in depth look at what this term means, and how you can apply it to analysing your property investment portfolio.
What Are Annualised Returns?
An annualised return is the return that an investment provides over a period of time. It is expressed as a time-weighted annual percentage.
Annualised returns are calculated based on adding first year returns to the principal amount for calculation of next year’s returns, and so on.
The rate of annual return is measured against the initial investment amount. It is calculated as a geometric average to show what you, as an investor, would earn over a period of time if the annual return was compounded.
What is a Geometric Average?
A geometric average (or mean) differs from a simple arithmetic mean. A geometric mean must be used when working with percentages (which are derived from values), whilst a standard arithmetic mean works with the values themselves. In short, a geometric average simply means that, because investment returns are compounded, they are dependent on one another.
A simple arithmetic average just doesn’t do the job when it comes to calculating investment returns, because it doesn’t account for compounding.
Calculating a Geometric Average:
To calculate the mean of an investment over a period of years:
- Remove any extraneous variables, such as mortgage payments, maintenance expenses, and so on.
- Add 1 to the % returns for each calendar year (to get them all to be positive).
- Then multiply them all together, and take the Nth root of the product of n numbers. (“N” depends on the number of years you want to annualise.)
So, a formula for calculating geometric average might look like this:
Year 1: Investment loses 37% of its value. The £1,000 you invested at beginning of year was only worth £630 by year end.
Year 2: The investment gained 26.5%. Taking into account the final value at end of Year 1, your 26.5% gain leaves you with £796.95.
Year 3: You gain 15%, but because you began the year with just under £800, you finish on about £920.
As such, your three-year annualised return comes to negative 2.86%
The sum looks like this:
(0.63 x 1.265 x 1.15)1/3 – 1
The factors in the equation are found by adding 1 to the yearly return % expressed as a decimal (so, 1 + (negative 0.37) = 0.63, and so on).
A geometric mean is sometimes defined as the “n’th root product of n numbers”, which – we’ll admit, does sound horribly complicated. Essentially, its main benefit is that the actual investment amounts don’t actually need to be known: instead, the calculation focuses on the return figures themselves, which allows you to draw direct comparison when looking at two investment options over more than one time period.
What’s The Difference Between Annualised Return and Cumulative Return?
A cumulative return demonstrates the aggregate effect of price change on the value of your investment, effectively telling you what exactly the investment has done for you over a period.
In order to calculate a cumulative return, you’ll need the initial price and the current price. Your formula will look like this.
Rc = ( Pcurrent – Pinitial ) / Pinitial
On the other hand, an annualised return, expressed via a geometric average, tells you what the annual rate of return would be that would produce the same cumulative return when compounded over the same period.
Well, okay, that does all look pretty scary, but in practice you’ll find that calculating your annualised returns is quite a straightforward way of accurately monitoring your investment performance over time.
All handy stuff when taking control of your property portfolio.
Of course, as always, if you have any questions please do get in touch. We’ll happily talk you through any aspect of property investment that you might be unsure about. It always pays to know the ins and outs of what’s going on with your money, and we’re here to help you do just that.