Investors judge the performance of an investment by looking at how much it brings in returns. They may employ multiple methods of calculating investment returns, the main two methods being cumulative returns and average annual returns. Both of these measurements have their benefits, and it is important to know the difference between them when you are making investment decisions.
Measuring Cumulative Return
Cumulative return measures the entire return of an investment relative to the principal amount invested over a specified amount of time. The amount of time may be months, one year or many years; the measurement term depends completely on the party making the measurement. To calculate cumulative return, subtract the original price of the investment from the current price and divide that difference by the original price. Express the answer as a percentage. For instance, if an investor puts $1,000 into a particular stock and the total value of her stock appreciates to $2,500 over a 10-year period, her investment has undergone a 150-percent cumulative return.
Measuring Average Annual Return
Also called the internal rate of return, the average annual return measures average return of an investment every year over a certain number of years instead of the total return amount at the end of that term. Like the cumulative return calculation, this is also expressed as a percentage. To make this calculation, subtract the value of an investment at the end of a particular year from the value of that investment at the end of the previous year and divide that difference by the value of the investment at the end of the year in question. Do this for every year of the term for which you wish to measure the average annual return. Express each year's return as a percentage. Average all of these percentages together to find the average annual return.
A common mistake inexperienced investors may make is to assume that they can divide the cumulative return by the amount of years in the term measured and get the average annual return. This, however, will not yield a correct measurement of the average annual return. For instance, an investment that results in an average annual return of 20 percent is going to yield a cumulative return of much higher than 200 percent after 10 years.
Choosing a Method
As both the cumulative return method and the average annual return method are both common, you may use either one to express the return on a particular investment. Cumulative return is the method to use if you are making projections based on an intent to sell an investment at a specific point, while average annual return is the method to use if you are trying to analyze the long-term health of a particular investment.