What is Annualized Return?
Annualized return converts a cumulative return over any period into an equivalent annual rate, enabling apples-to-apples comparison between investments held for different durations. If an investment grows 50% over 3 years, the annualized return is not 50/3 = 16.7% but rather 14.5%, calculated as (1.50)^(1/3) - 1. This geometric average accounts for the compounding effect and provides a more accurate picture of annual performance.
Why Simple Averages Mislead
Consider an investment that gains 100% in year one and loses 50% in year two. The simple average return is +25%, but the actual result is zero: $100 becomes $200, then falls back to $100. The annualized (geometric) return correctly shows 0%. This discrepancy grows with volatility, which is why annualized returns are the standard for evaluating investment performance over multiple years.
Key Considerations
When comparing fund performance, always use annualized returns rather than cumulative returns. A fund showing 200% cumulative return over 20 years (5.6% annualized) is less impressive than one showing 150% over 10 years (9.6% annualized). Also verify whether reported returns are before or after fees, as even small fee differences compound significantly over long periods.