Difference Between Annualised Return vs Absolute Return Explained

When evaluating an investment, one significant distinction exists between absolute vs annualised return. Absolute return captures the overall percent change in the value of the investment in a fixed period. On the other hand, annualised return corrects the performance in terms of the year. It reduces the impact of the investment duration made for varying durations.

Understanding these concepts enables investors to make good decisions. It helps them compare potential investments and strategies regarding their stated goals and objectives. This article will demystify these investment techniques.

Absolute return is the actual return made by a mutual fund, irrespective of the market index. After determining the cost of investing, you can choose the absolute return. However, you must consider all those dividends and capital gains received in the investment period.

Historically, relative return involves comparing a specific fund's performance against other mutual funds. In contrast, absolute return evaluates the fund's actual return figures. This makes it a valuable tool for investors considering capital safety and constant. However, moderate, persistent, positive returns are more critical than market-beating ones.

How to Calculate Absolute Return?

To calculate absolute return, you measure an investment's total gain or loss over a specific period, expressed as a percentage. The formula for absolute return is:

Absolute Return = (Final Value − Initial Value) / Initial Value × 100

The term annualised return, often called CAGR, is the yearly rate at which the mutual fund generates its returns over a stated period. It signifies the compounded rate of return that an investment has earned during its tenure. Given that the earning rate will remain the same for every single year.

In comparison to the actual returns, the annualised returns divide the performance into a constant yearly rate, enabling comparisons with other funds with different investment horizons. This return is preferable to the traditional return calculation between two-time points for long-term investment.

How to Calculate Annualised Return?

Annualised return calculates the average yearly return of an investment. This makes it easier to compare different investments over time. The formula for annualised return is:

Annualised Return = (1 + absolute return)1/n − 1

Where n is the number of years.

Absolute and annual returns are vital criteria for assessing investment performance. They will show investors how much their investment has grown in a year. Here is an example to understand it better:

You invest ₹1,00,000 in a mutual fund. After 3 years, your investment grows to ₹1,50,000.

1. Example of Absolute Return

Then, the absolute return for this investment would be calculated as follows:

Absolute Return = Final Value - Initial Value Initial Value x 100

i.e., Absolute Return = (1,50,000 - 1,00,000)1,00,000 x 100

                                    = 50%

So, the absolute return over 3 years is 50%.

2. Example of Annualised Return

For the same case, the annualised return will be calculated as:

Annualised Return = (1+ Absolute Return)1n - 1

i.e., Annualised Return = (1+0.50)13 - 1 

                                        = (1.5)13 - 1

                                        = 0.1447 x 100

                                        = 14.47%

So, the annualised return over 3 years is 14.47%

Absolute return and annualised return are two terms that an investor should know. Both must be compared to determine which better suits your investment evaluation needs.

• Absolute return computes an investment's total percentage gain or loss over a certain period. It is most suitable for short-term investors who have to know the direct impact without incorporating time.
• Annualised return is used to measure the average rate of return in a year using compounding factors. It is, therefore, more standardised, which enables one to compare different investments with varying holding periods.
• The absolute return is only advantageous for short-term investors or those tracking fixed periods. Annualised return, for long-term investors comparing multiple assets over time, is a far more reliable means of evaluating the investment.

Considering both differences, one can conclude that each duration has benefits. Absolute return exhibits the actual monetary outcome of an investment. On the other hand, annualised return provides a consistent basis for comparing various investments. Both are valuable in evaluating an investment. However, decisions depend on one's risk tolerance and the goals one has set.

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