Investing your money is a great way to grow your wealth, but it’s necessary to equip yourself with relevant terminologies and formulas.
‘Annual Rate of Return (ARR)’ is one such concept every investor should know about.
The ARR measures the percentage increase or decrease in an investment’s value on an annual basis, considering both gains and losses.
In this article, we’ll dive into the function and formulas used to calculate the ARR, so you can better understand how to evaluate your investments’ performance.
What is Annual Rate of Return, and How to Calculate it?
Annual rate of return is a measure used to determine how much money an investment has earned for a given investment period on an annual basis. It is expressed as a percentage of the initial investment.
This measure is useful for comparing the performance of different investments, as it allows you to see which ones provide the highest returns.
To calculate the ARR, follow these steps,
- Step #1: Determine the Initial Investment (IV). This is the initial amount of money invested in the investment.
- Step #2: Determine the investment’s Ending Value (EV). This is the value of the investment at the end of the investment period.
- Step #3: Determine the Number of Years (n) for which you want to calculate the ARR. This is the duration of the investment period.
- Step #4: Plug the values of IV, EV, and n into the formula and calculate ((EV / IV) ^ (1 / n)) – 1.
- Step #5: Multiply the result by 100 to express the ARR as a percentage.
For example, if you initially invested $10,000 in an investment, and it grew to $15,000 after 3 years, the ARR would be calculated as follows,
EV = $15,000
IV = $10,000
n = 3
ARR = ((15000 / 10000) ^ (1/3)) – 1 = 0.1447 or 14.47%
So, the Annual Rate of Return (ARR) for this investment is 14.47% over a period of 3 years.
Note: The annual rate of return is not guaranteed and can vary widely depending on market conditions and other factors.
Importance of ARR in Financial Planning
The Annual Rate of Return (ARR) is an important financial metric that is widely used in financial planning for several reasons,
1. Performance Evaluation
ARR helps investors assess the performance of their investments over time.
By calculating the ARR, investors can gauge the effectiveness of their investment decisions and strategies. It allows them to evaluate their investments’ profitability and growth potential and make informed decisions about their investment portfolio.
2. Goal Setting
ARR can assist in setting financial goals and targets. It helps investors understand the rate of return they need to achieve to meet their financial objectives, such as retirement savings, education funding, or buying a house.
Investors can use ARR as a benchmark to monitor their progress toward their financial goals and adjust their investment strategy accordingly.
3. Risk Assessment
ARR is a useful tool to assess the risk associated with an investment. Investments with higher ARR may indicate higher potential returns but may also come with higher risk.
On the other hand, investments with lower ARR may be less risky but may also offer lower returns.
4. Investment Decision-making
ARR plays a crucial role in investment decision-making. It allows investors to compare the potential returns of different investment opportunities and choose the one that aligns with their financial goals and risk tolerance.
Investors can use ARR to evaluate the historical performance of an investment, project future returns, and decide whether to buy, hold, or sell an investment.
Annual Rate of Return vs. Return on Investment
The Annual Rate of Return (ARR) and Return on Investment (ROI) are both financial metrics used to assess the performance of investments.
But they have some key differences, as mentioned below.
1. Time Period
ARR represents the percentage return earned for a given investment period on an annual basis. It measures the compounded growth rate of an investment over time.
On the other hand, ROI is calculated as a ratio of the overall gain or loss on an investment relative to the initial investment, expressed as a percentage.
2. Compound Growth vs. Simple Gain
ARR considers the compounding effect of returns over time, assuming that the returns are reinvested. It reflects the annualized growth rate of an investment, considering both the initial investment and any gains or losses accumulated over the investment period.
ROI, on the other hand, simply measures the total gain or loss on an investment relative to the initial investment without considering compounding.
ARR is calculated using the formula ((EV / IV) ^ (1 / n)) – 1, where EV is the ending value, IV is the initial investment, and n is the number of years.
ROI, on the other hand, is calculated as (Net Profit / Initial Investment) x 100, where Net Profit is the gain or loss on the initial investment.
Understanding the annual rate of return is an essential component of evaluating investment opportunities and assessing the overall performance of your portfolio.
Using the formulas and functions discussed in this article, you can gain insight into how your investments are performing and make informed decisions about where to allocate your resources in the future.
With careful attention to the annual rate of return, you can maximize your investment potential and work towards achieving your financial goals.