An annualised return is the average amount earned by an investment each year over a certain period of time if the annual return was compounded. Compounding means investment returns, from one year to the next, are dependent on each other.
For example, if you invest £1000 in a FTSE 100 fund and the fund loses 25% in the first year, and then gains 15% and 12% in the two subsequent years, the average annual return would be:
(-25% + 15% + 12%) /3 = 0.6%
Based on this calculation, at the end of the third year your investment pot should stand at £1006. However, it doesn’t.
That’s because you lost 25% in the first year, meaning you started year two with a pot of £750. The return was 15% in year two, but that was on the £750, leaving you with £862.50. The return in year three was 12% on the £862.50, leaving you with £966 at the end of year three. That’s a three-year annualised return of -3.4%.
