Return on Investment: Annualized vs Simple percentage gains

To monitor your performance over the long term or against benchmarks like the Nifty, the annualized return is more informative because it describes the performance in consistent, annual terms.

The last few years have been good for your investment portfolio. Some of your mutual fund investments have done exceedingly well. But knowing that your investment has doubled (i.e. grown 100 percent) is meaningless unless you know over what period this took place -- doubling over 5 years indicates it has grown at a rate of 14.86 percent a year, doubling over 10 years means it has grown at 7.17 percent a year, while doubling over 15 years means it has grown at only 4.73 percent a year.

The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.

There are two ways to calculate gains:

1.     Simple percentage return or return on investment

2.     Annualized percentage gain

1. Simple percentage return or return on investment: This is the simple percentage gain of your holdings over the total investment amount, not annualized as in the IRR calculation. Simple percentage return works over any time period. It simply indicates the change from one point in time to another.

Simple % return = (Current Value-Amount invested) / (Amount invested) X 100

For an investment that lasts exactly one year, the simple percentage return is the same as the internal rate of return (IRR) below.

2. Annualized percentage gain: Annualized return or internal rate of return (IRR) is used show how an investment has performed over time. IRR calculates the percentage return on an annualized basis regardless of the actual investment period. It doesn't matter whether you hold an investment for one year, five years, or even fifty years - the internal rate of return will tell you the annualized percentage returns of that investment over any period of time.

To get an accurate picture of your performance over the long term or against benchmarks like the Nifty, the internal rate of return is more informative because it describes the performance in consistent, annual terms.

How do I compute annualized gains? The easiest way to do these challenging calculations is in Excel using the XIRR function – you need to have the investment dates, investment amounts and the current value handy.

The Microsoft Excel XIRR function returns the internal rate of return for a series of cash flows that may not be periodic. Because you provide the dates for each cash flow, the values do not have to occur at regular intervals.

The XIRR function is a built-in function in Excel that is categorized as a Financial Function. It can be used as a worksheet function (WS) in Excel. As a worksheet function, the XIRR function can be entered as part of a formula in a cell of a worksheet.

Which one should you use? At the end of the day, each calculation is useful in its own way. To monitor your performance over the long term or against benchmarks like the Nifty, the annualized return is more informative because it describes the performance in consistent, annual terms. However, for determining your gains over a shorter period or understanding your cash-on-cash returns, the simple percentage return is easier to calculate and gives you everything you need. Simple percentage gains works better in the short-term for investments such as equity funds that have more ups and downs. Annualized percentage gains should be used for almost everything else, and over all time periods more than a year.

Your broker, distributor or investment adviser should be able to share the annualized percentage gains (IRR) and simple percentage gains for your investment portfolio – ask for both these numbers to find your true portfolio performance!