Annual total return definition
Annual total return meaning
Annual total return calculates the yearly average return of an asset for a given period. It can be quite a practical measurement for comparing different assets and investments. It is especially useful when analyzing the return generated on investments over the same time span, but can be used for investments over differing periods as well. The measure includes different types of returns. Thus, investments generating only capital gains can be easily compared with investments generating capital gains and dividends, or other income. Moreover, the annual total return can be used to see how an asset held in a portfolio has performed against an index performance for the same period.
What is the annual total return?
It is a measure which is based on the difference between the purchase price and sale price (capital gain from price changes) and other income (from dividends or interest payments) earned from the investment. The annual total return estimates an asset’s return while taking into account the concept of compounding. More precisely, calculations can be performed assuming reinvestment of dividends and other income.
When presented or calculated, the annual total return can be broken down to its components. The annual total return on a stock can be broken down by stating the percentage coming from price appreciation and the percentage coming from the dividends or the dividend yield.
One major disadvantage of using annual total return is it does not account for the possible volatility which can occur in returns each year. Over a period of several years, the return could be high and positive in the early years but negative during later years, or vice versa. Estimating the annual total return may provide a positive measurement of the average yearly return without showing that some years were negative. This drawback can be applicable when investing in mutual funds. For example, let’s assume that the returns from mutual fund for each year, over a period of 7 years, are: 25%, 28%, 18%, 10%, -7%, -3%, and -2%. Estimating the annual total return could show an average positive return for each year. But the reality is that the fund has done worse in the last three years, which should raise questions about the performance of the fund.