There is more than one way to calculate a yearly return on investment (ROI). Unfortunately, not some, not many, but MOST financial institutions use ways of calculating yearly returns that yield absolutely misleading figures at best.
According to Investopedia a return on investment (ROI) “is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.” The return on investment formula:
According to Investopedia a return on investment (ROI) “is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.” The return on investment formula:
For example, let’s say you invest $100 and your investment grows to $125. Your ROI would be ($125-$100)/$100 = 25%.
“Average” Returns vs “Annualized” Returns
It is important to compare different investments over a period of time to help determine which investment performs better. That is why many investments are quoted in terms of returns per year. For example, the annual return for Investment A between 2007 and 2012 was 11% whereas the annual return for Investment B over the same time frame was 10%. It would seem that Investment A is better than Investment B, but that is not always the case. First we must understand that there are two primary methods of determining yearly returns, the “average” and the “annualized” return.
The average return is calculated by adding all of your gains and losses per year then dividing it over the number of years. For example, if an investment had a loss of 50% in the first year then a gain of 50% in the second year the average return would be 0%.
Unfortunately, however, 0% is not your actual return. Let’s take a closer look using actual numbers, assume you invest $500 then by the end of the first year after a 50% loss you would have $250
and by the end of the second year after a 50% gain you would have $375.
It is clear that your ending value of $375 is less than your starting value of $500 which is a net ROI of -25% not the commonly advertised 0%.
Furthermore, the true annualized return of this example (see below for definition) is -13.4%. The problem with the average return, is that it is a mathematical simple average, and it never calculates the actual return whenever there is a negative year involved. FACT: The average return is used by most financial institutions, so in the event there is a negative year, it will show a return that is larger than the actual return. In some cases, the average return could be positive while the actual return is negative.
In short, when calculating the average return, Investment A that has a yearly return of 11% may actually have performed worse than Investment B that has a yearly return of 10%, if Investment A had a negative/s year/s and investment B did not. To get a true apples to apples comparison AND the actual return of an investment make sure to use the annualized return method of calculation.
True investing makes sense. Learn how actual returns can really help you achieve financial security by attending one of our events.
In short, when calculating the average return, Investment A that has a yearly return of 11% may actually have performed worse than Investment B that has a yearly return of 10%, if Investment A had a negative/s year/s and investment B did not. To get a true apples to apples comparison AND the actual return of an investment make sure to use the annualized return method of calculation.
True investing makes sense. Learn how actual returns can really help you achieve financial security by attending one of our events.
| Click the image to the right to learn more about the annualized return and how it is calculated. Click here to use a CAGR calculator (you will be directed offsite). |  |
RSS Feed
