Knowing Absolute Return vs Annualised Return
Absolute Return
Absolute return is the total gain or loss on an investment over a given time period that does not account for the time it took to achieve those returns.
It is commonly expressed as a percentage of the initial investment.
Example:
If you invest Rs 1,00,000 in a stock and it’s value grows to Rs 1, 50,000 over three years, the absolute return is Rs 50,000, or 50% more than the initial investment.
Features of Absolute Return:
Simplicity: Absolute return is simple to understand and calculate because it is simply the difference between the final and initial values.
Time-Independent: It does not take the investment period into account, making it suitable for investments with varying time frames.
Annualised Return
Annualised return, on the other hand, takes into account the investment's time horizon. It calculates the return if the investment had been made at the same rate for a year.
Example:
Using the same investment of Rs 1,00,000 that grows to Rs 1,50,000 over three years, the annualised return is 14.47%.
The formula to calculate annualised return is:
A = P x (1+r/n) n X t
Where: A = Final amount (Rs 1,50,000),
P = Initial amount (Rs 1,00,000),
r = Annualised return rate (unknown,
to be calculated)
n = Number of times interest is
compounded per year (assuming it is compounded annually, so n = 1)
t = Time period in years (3 years)
Importance of Annualised Return:
For Comparison: Annualised returns allow for the comparison of investments over different time periods.
By converting the returns to an annual rate, it's easier to compare different investments or the same investment over various durations.
Time-Dependent: Reflects the impact of compounding, taking both the rate of return and the time period over which the return was obtained into account.
Absolute Return vs Annualised Return
Time Factor: The total gain or loss is reflected in the absolute return, which is unrelated to time.
In contrast, the annualised return is time-dependent, reflecting the rate of return over a typical one-year period.
Calculation: Absolute return is a simple calculation (final value minus initial value), whereas annualised return requires a more complex calculation that accounts for compounding over time.
Application: Absolute return is useful for calculating the total return on an investment, whereas annualised return is more useful when comparing different investments or evaluating performance over time.
Absolute and annualised returns are both important metrics in investment analysis, serving different functions.
Absolute returns provide a straightforward measure of the total returns, while annualised returns offer a nuanced view, factoring in the time factor and enabling comparison across various investment opportunities.
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