Cumulative vs. annualized returns

Question: Can you explain the difference between cumulative and annualized returns?

Also, where do since inception returns fall under? Asked at “Ask a Friend, Ask Efren” free service through www.personalfinance.ph, Facebook, and SMS.

Answer: I admit, the historical performance numbers for investments can get quite confusing.

So, why don’t we start with an example.

If you were asked to choose between two investments, Fund A that has a since inception return of 100% and Fund B that has a since inception return of also 100%, which would you choose?

Please remember that you can only choose one.

Do you have your answer already? Are you indifferent between the two and would rather split your money between them, which as I said is not allowed in this exercise?

Or are you confused and feel that you need more information?

The truth of the matter is that there is one piece of information that is lacking.

Now if you say that you need to know over what period the returns were generated, then you are correct.

If Fund A earned its 100% return over a 10-year period and Fund B earned its 100% return over a 5-year period, which would you now choose?

If you answered Fund B, then you are absolutely correct in your choice because Fund B would have effectively earned more for you.

The previous computations are cumulative return computations that do not take into consideration the time value of money.

Since inception returns are actually cumulative return computations.

The better measure would be annualized returns because regardless of the period over which they were earned, annualized returns already take into consideration the time value of money.

Now what is time value of money? It simply means that money received today is worth more than money received tomorrow.

Put another way, money invested 10 years ago is worth more than money invested 5 years ago.

Therefore, if you had invested the same amount of money in Fund A and Fund B but received the same amount of return for both, then you would have effectively earned more from Fund B.

On an annualized return computation, Fund A would have returned only 7.2% p.a. compounded and Fund B would have returned 14.9% p.a. compounded.

While since inception and cumulative returns are great for marketing (e.g. 100% cumulative vs. 7.2% annualized returns for Fund A), they do not paint the true picture.

Focus instead on annualized returns. If you do not know how to compute them, ask for help from your friendly financial planner.

Next week, let’s talk about computing your actual investment return that may be different from your investment’s reported return.