Posted over 6 years ago

How to Properly Calculate an Annualized Return

The S&P 500 index has increased from 1,549.38 at the height of the market in October, 2007 to 2,091.48 at the present. What is the annualized rate of return since then? Its been over eight years, that's long enough that we should earn around what Wall Street considers the "average" return, right? I've seen some meme's on Facebook showing how obama has grown the market. It must be pretty high, right?

Do you know how to calculate the return on an investment (ROI)? I think most people know how to calculate an ROI. Its pretty simple math. A recent conversation (debate) with a real estate investor here on BiggerPockets.com prompted me to write this article.

This investor told me that his stock market holdings were up 50% since 2007. He sounded excited about this, almost bragging. 50% over 8 years doesn’t sound like a great return to me. Especially with the risk of losing 30-40% in any given year. After all, what does this mean on an Annual basis. So what does this look like when you convert it to an annualized rate of return. Note the terminology. It makes a big difference.

The ROI is easy to calculate. Where I see most people making mistakes is when they try to convert their nominal return to an annual number.


What is the Annualized ROI if your investment increased 50% over 8 years? The Return is 50%. That much is simple. But we really need to convert it to an annual rate of growth to compare it to what we could have made in other investments. The financial experts on Wall Street tell us that the market appreciates at a long term average of 9%. What does that number mean? How did they calculate it?

Do you simply take 50% and divide it by 8 years to get an average? No.

Let’s put this into some real numbers so you can see what happens when you use incorrect calculations. Let’s say this investor had $1,000 in mutual funds and he turned it into $1,500 over 8 years. The $500 gain divided by his $1,000 investment is how we get the 50% return on investment. To get a simple average we divide 50% by 8 years for a 6.25% Average Return.

This number is useless and doesn’t tell you anything about the investment.


Here’s why:

If I stuck $1,000 into an investment that pays 6.25% annually, here’s what my account balance would look like each year:

Aaeaaqaaaaaaa Ae Aaaaj Dg5 Mz Ix Zg Fj Lw Fl Yw Qt N Dkx Yy04 M Ddj Lw Uz N2 Ni Md Nm Nta5 Mq

See the problem with using a simple average? Look at the account value at the end of the 8th year. I made $624.17. So how did my investor friend make a 50% return and I made a 62.4% return if we’re both earning 6.25%?

Its simple.

He actually earned something less than 6.25%.


The average doesn’t take compounding into effect. Compounding is an incredibly powerful force and you can’t overlook it.

I don’t care about average returns. They’re meaningless to me. If you’ve kept up with my articles over time, you know that the Rule of 72 is my favorite rule in finance. If you divide 72 by the interest rate you are earning, the result is the number of years it will take to double your money.

If you are going to accurately employ the Rule of 72, then you need to know the true annual rate of return.

I want to know the annualized rate of return for my investor friend. What rate of return would result in $1,000 turning into $1,500 after 8 years?


To get the correct answer requires a little more sophisticated math. Compounding interest results in Exponential Growth. So we need to play with exponents.

If I am earning 10%, then I can calculate my expected return by multiplying my investment amount by 1+10%. For example, $1000 investment * 1.1 = $1,100. $100 is a 10% return.

If I roll this investment over for a second year, its $1,100 * 1.1 = $1,210. See how 10% compounding growth for two years gives me a 21% Return? (or a meaningless 10.5% Average Annual Return)

This can also be written as: $1,000 * 1.1 * 1.1 = $1,210

Aaeaaqaaaaaaa Ah6 Aaaaj Dk1 Mtu0 Zw Rm L Tkx Yjct Ng Ux My1i Zgq2 L Tc5 Y2 Ez Nt Vl Z Tll Zq

So if I kept this investment rolling for 5 years, I could easily calculate my expected rate of return by just typing =1,000 * 1.1^5 into Excel. The caret symbol denotes an exponent. This is the same as Aaeaaqaaaaaaa Af4 Aaaajg Rl Mm Y5 Zt Ew Lt Nl Ot Et N Ddh My05 Mzhl Lta3 M2 Iy Ngu4 Ndy2 Na

This is all great for projecting forward into the future, but how do we work backwards to solve for the rate if we know that we ended with $1,500, started with $1,000 and were invested for 8 years?


Easy. You need to find the root. If I solve for the square root of

Aaeaaqaaaaaaa Ad Aaaajd Qx Yz Jl Md Fl L Tc3 Yjkt Ng Rl My05 M2 Iy L Tgw Nw Vh Yj Y2 Mtu4 Ng

I get back to 1.1. If I subtract “1”, I get the 10% rate that I started with.

How do you do this on a calculator or in excel?


That’s fairly easy as long as you know that the root can also be expressed as the reciprocal of the exponent.

Huh?


In layman’s terms, if

Aaeaaqaaaaaaa Ad9 Aaaaj Dkz Od Rk Mte1 Lw Fh Nj Ut Ng Rk Ni1h Zm I0 Lwu5 Mz Jj Od Fh Mz E3 Za

is what you would get if you invested 10% for 8 years (the exponent is the number of years), then

Aaeaaqaaaaaaa Ag Uaaaaj Dg4 Yjk1 Mz Jj L Tk5 Mj Et Nd Fm Mi05 Mz Nj Lw Jm Zwu0 Mdq1 Zw Ey Oq

would be the reciprocal (root). One-eighth is the reciprocal of eight. (It's the 1/xbutton on your calculator.) So…

Here’s what it would look like in excel:

=(V-End/V-Beg)^(1/Yrs)-1

Where V = Value

So let’s figure out my friend’s Annualized Rate of Return:

Value at End = $1,500

Value at Beginning = $1,000

$1,500 ➗ $1,000 = 1.5

8 Years

Aaeaaqaaaaaaa Ae6 Aaaajgy4 Yjg4 Ntq2 L Tcw Mjkt Nd Bl Os1h Mm M4 L Tkz Zjhk M2 Nm Ng Ri Yq

5.2% is a hell of a lot different from 6.25% average isn’t it? It will take him 13.8 years to double his money at this rate of growth. He's underperforming the long term average return of the market by 4%. Did Wall Street analysts calculate the annualized return or are they giving us the Average? Hmmm.

Does that 50% return sound exciting now?

Let’s check our math:

$1,000 * (1.052) * (1.052) * (1.052) * (1.052) * (1.052) * (1.052) * (1.052) * (1.052) = $1,500

These calculations really aren’t that hard to program into excel. Remember also that you can use any time period. It doesn’t have to be an integer. If you’re a real estate investor and you turned $10,000 into $15,000 in a quick 6 month flip, just run the same calculation for your TRUE annualized ROI. (Use 0.5 for “years”) Most people incorrectly just double their actual return to estimate their annualized ROI.

Homework Assignment:

Calculate the annualized rate of return on the S&P 500 using the numbers from the first paragraph. Post the answer in the comments below.

In my next article, we’ll use this math to debunk the ways that the media and politicians tend to mis-state data.



Comments (9)

  1. Great article, Thomas. I think annualized return is a metric that a lot of people struggle to understand, so well done explaining it so thoroughly. 


  2. Thomas, Happy Memorial Day.

    Many thanks for taking the time to provide your perspectives on this key component of Real Estate Investing math/analysis.  I'm sure there are plenty of folks out there who find this to be an obscure concept, but you lay it all out pretty clearly.  Glad I ran across this Blog piece - am bookmarking immediately.  Have a good one.

    ~  Albert


  3. Good article, thanks. This is useful - plus I love working the numbers when it comes to my investments.

    Listening to some Dave Ramsey (who I actually like) books recently, I noted that he says it should be easy to 12% in a mutual fund. Out of curiosity, I thought I'd look at the S&P 500. So I actually plugged in the annual increase/decrease since 1970. Interestingly, the average was around 12%, but the annualized return was very close to 9%.

    I could have used your formula and saved myself some time. :)

    Cheers.


    1. To me, the scary thing about the "average" rate of return on the S&P 500 is the standard deviation around the "average". I looked at the standard deviation since 2000 and came up with 18%. That's a bell curve with the tails 36% on either side of the 9% average. In his book, Ramsey suggests that it is never too late to get started investing. If you can't afford to lose 27% in a market correction (somebody retiring in near future), then you shouldn't be in the market. There is a time when it is too late.


  4. Duane gets the right answer. If the market index was at 1549.38 and grew at 3.85% for 8.5 years, the market would be 2,136 now. 


  5. Use Excel formula- Rate --- =RATE(8,0,-1549.38,2096.48,0) - it returns 3.85% close enough.

    For the "50% return over 8 years" - > =RATE(8,0,-100,150,0) - returns 5.2%


  6. I calculate the answer as follows:  

    Assuming Monthly Compounding

    V0 - 1549.38 - S&P 500 10/2007 

    Vn - 2096.48 - S&P 500 04/2016 

    n - number of compounding periods (4/2016 - 10/2007) or 102 

    Algebraic Formula = (((Vn/V0)^(1/n))^12)-1 = Annual Return

    Vn/V0 = 1.353109 

    1.353109^(1/102) = 1.0029692

    (1.0029692^12)-1 = 3.62% Annual Return 

    3.62% Annual Return     


  7. great article, I see people using the average all of the time, ignoring what they have added in cash, or not counting the losses they have hit.  In addition, when considering rei, most that have never done it only consider the tax breaks and appreciation and minimizing the value of leverage, cash flow, and principle pay down, not to mention my favorite aspect, control.


    1. Pete - The other common mistake is to not put any value on your own time when you do the work yourself. I've got a buddy who is a 6-figure a year earner and he bragged about his return on tax deed property he bought at auction, fixed up, and sold. If he accounted for his true $100/hour cost, I'm pretty sure the margins would not have been brag-worthy.