Total versus Annual Returns

Jul 25, 2013: While studying the performance of a stock or mutual fund we invariably come across these two terms - Total (also called Cumulative) and Annual return. If we are not aware of their definitions and what they represent, we may get unduly excited by looking at the wrong figures.

Annual Return - It represents the rate of growth of an asset for one year taking into account dividends, capital gains and reinvestment of distributions. If the figure is expressed as a percentage yield the effect of compounding interest has been factored in as well. Alternative names are yearly return, one-year return, 1-year return, compounded rate of return, annualized return.

Total Return - The cumulative or total return on an investment over a specified time period, usually several years, including dividends, capital gains and reinvestment of distributions. Another term used for the same is cumulative return.

Average Annualized Return - The average of each year's annual return over a multi-year period is given by average annualized return. Thus by definition dividends, capital gains and reinvestment of distributions are factored into as well as the price change or growth of the asset. It is also referred by the name average annual return.

Typically most performance charts display average annualized return and total return.

How about an example?

Let us look at the following charts. Assuming an initial investment of $1000 and yearly return of 10% every year the principal grows to a healthy $2594 after 10 years. Please see the chart below.

Now for the return rates let us study the second chart. The annual return for each year is 10% as we have assumed. However the total return for 10 years is whopping 159%.

While the cumulative figure is important, as long term investors we should focus more on consistent performance. To us, a higher average annualized return for a longer period is more important than astronomical total returns over shorter periods of time. Thus we would settle for a fund with 11% average annual return for 10 years rather than one with 160% total return for 10 years.

The keys to successful investing lie in application of care while comparing performance data and being knowledgeable about evaluation metrics.

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