What is a Compound Annual Return?

The compound annual return has to do with the amount of growth that is achieved by an investment within a calendar year. Also known as an average annual return, the calculation takes into consideration any and all activity involving the investment during the period cited. Generally reported as a percentage, the compound annual return can also be calculated using an assumed constant rate, although it is possible to allow for variations in the rate during the twelve month period under consideration.

One of the important functions of calculating the compound annual return is to assess the rate of annual return on a given investment. Using the historical data on hand, it is possible to ascertain the worth of continuing to hold onto the investment. This can be accomplished by comparing the compound annual return for the most recently completed year with the percentage return of previous years.

If the rate of interest and other factors tend to allow the investment to generate a return that is consistent or even indicates a slight upward growth trend from year to year, the investor is likely to hold on to the asset. However, if the calculation of the current compound annual return indicates that the investment is beginning to slow in earning a return, there is a good chance that the investor will wish to sell off the investment and acquire a new security with a greater potential for earning a return.

Because the calculation of the compound annual return is in the form of a percentage, the figure is also considered to be helpful in evaluating performance during the current uncompleted annual period. For example, if an investment demonstrated an overall compound annual return of 25% during the most recently concluded annual period, an investor may choose to use that figure as a benchmark in evaluating monthly or quarterly performance of the security during the new calendar year. By employing the compound annual return as a standard for the current incomplete year, the investor can often spot trends and take appropriate action if market changes or other factors indicate the investment will not perform up to par for the remainder of the current year.