Log In Compound Return: Definition, Formula & Calculation
There can be several different ways to measure the overall success of an investment. Typically, monitoring the gains and losses will provide some actionable insights into how a specific investment is performing. Yet, there are also a few strategies you can use to forecast and measure how an investment is doing.
One of the most effective ways to do this is by measuring the compound return. But how exactly does this work and what do you need to know? Continue reading to learn more, including some examples and how to calculate it yourself.
Table of Contents
KEY TAKEAWAYS
- When a compound return is expressed in annual rate terms, it’s referred to as a compound annual growth rate (CAGR).
- Average annual return doesn’t take volatility into account while the calculation for a compound return does. This creates a better accuracy of calculation.
What is a Compound Return?
A compound return is a measure of how well an investment’s performance is doing over time. It’s typically expressed as a percentage that applies annually. It ultimately represents the gains and losses on the originally invested amount.
In comparison to the average annual return, it’s much more accurate. Whereas average annual return doesn’t consider the effects of compounding, the detailed calculation for compound returns considers the cumulative fluctuations between gain and loss.
While compounded returns can increase already sizable investment funds, they can work in the opposite way as well on the annual interest rate for any principal balances on your debts. Making you responsible for higher payments to the financial institution you owe money to.
Compound Return Example
Compound returns are used when dealing with invested capital. To truly understand how this works, we’ll go over an example. Let’s say that the annual compound return for an investment is 12% over a period of five years. If your initial investment is $1000 then you would see the following returns compounded over the course of five years using this compound interest calculation:
- $1000 x 12%=$1,120
- $1210 x 12%=$1,254.40
- $1,254.40 x 12%= $1404.92
- $1404.92 x 12%= $1573.51
- $1573.51 x 12% = $1762.33
So essentially the money you earn from interest is added into the original principal investment year over year. Which means you’re earning more interest from the interest payment you’ve received. These types of investments over time can easily add up to a healthy return if there are no balance withdrawals. That’s the power of compound interest.
This doesn’t necessarily mean that you’re receiving a consistent return of 12% over the course of those five years. Any combination of gains or losses in interest rates over the five-year investment period that resulted in a final return of $1,762.33 would be a compound return of 12%.
Summary
Overall, compound returns put to good use can help you estimate how much of a return you’ll receive on an investment over a period of time. It’s a much more accurate measure than annual average return since it takes fluctuations in the rate of return into account. Having compounded returns investments is a smart move since you’re earning money on top of your initial earnings. When it applies to any debts you have, it can be detrimental.
FAQs About Compound Return
The rule of 72 basically tells you how many years it will take for an initial investment to double with a given rate of return on investment.
There are several ways to calculate a compounded return. One of them is to multiply the initial investment by the interest rate to the power of the number of years within the return period. So with an interest rate of 12% over a 5-year period of time and an initial investment of $2000, it would look like this:
1) 0.12 x 2000 = 240
2) 2000+240=2240
3) repeat for the number of years in the time period.
You could also choose to use a compound return calculator if you’d rather avoid the math.
Yes, stock returns can be compounded.
Share: