When investing, especially in stocks, your returns can fluctuate wildly from year to year. For this reason, knowing an asset's return for a single year isn't too helpful when deciding whether or not to invest. Calculating annualized returns for longer time periods can help you better assess how the investments you currently hold are performing, and can also help you choose future investments.
Calculating annualized returns
First, determine the investment's overall total return over the holding period you're examining. You can find this by subtracting the investment's current value from its original value, and then dividing by the original value.
Next, divide the number one by the number of years of returns you're considering. For example, if you're looking at a 10-year holding period, dividing one by 10 gives 0.1. To annualize your returns, raise the overall investment return to this power, and then subtract one.
Let's say that you invested $10,000 in Microsoft 10 years ago, and that your shares (including reinvested dividends) are currently worth $23,800. Using this information, you can calculate your total investment return to be:
So, your total return over a decade has been 138%. Since we're considering a 10-year period, I'll use 0.1 as my power to calculate the annualized return:
Translated to a percentage, this shows that your 10-year investment in Microsoft produced an annualized return of 9.06%.
Over the past decade, the total return of Microsoft stock has varied wildly, ranging from a loss of 43.8% in one year (2008) to a 53.4% gain the next. The stock had three losing years out of the past 10, and five years where its total return exceeded 20%. The point is that any one of these years would be a poor indicator of the stock's performance as a long-term investment. For this reason, knowing the annualized return is more helpful to investors when analyzing the long-term performance of stocks than any short-term performance figures.
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