A compound return is the amount of return generated after considering the impact of a combination of losses and gains that are experienced within a specified period of time. Typically presented as a percentage, the return helps to identify if an investor ultimately earned a return on the underlying capital for the period, or if the losses outweighed any gains and resulted in a net loss. While this type of return can be calculated for any type of time frame, the strategy is more often applied to annual periods, and is known as a compound annual growth rate.
Determining the compound return for a given period is helpful in identifying if a return on the investment has actually taken place, and if that total return is enough to motivate the investor to hold on to the asset for a longer period of time. For example, if an asset was worth 50% more after holding it for five years, that asset is said to have an annualized return of 10%. This does not necessary mean that the investment earned an actual annual return of 10% each year; chances are that the asset achieved a higher return in some years and a lower one in other years. Assuming that the investor is happy with that 10% annual compound return over the five years, there is a good chance he or she will hold on to the asset. If the investor was hoping to earn a higher compound return for each of the five years, the investment may be sold and the investor will purchase a new asset that is believed will generate a higher annualized return.
It is also possible to calculate a compound return for shorter periods of time. An investor may choose to determine the return, allowing for gains and losses, on a quarterly basis. At the end of the calendar year, the investor looks at the cumulative effect of the upward and downward movements related to the asset, and decides if the amount of return generated is sufficient to merit holding on to the asset for another year. This approach makes it possible for investors to avoid reacting to temporary slumps in the value of the asset, while still limiting the long-term risks involved with owning the investment.
As part of the calculation of the compound return, investors also have the chance to take note of recurring trends that occur with the gains and losses associated with the investment. Data of this type can also be key to deciding whether to sell the asset, or hold onto the investment for a longer period of time. If the periods of gains easily offset the losses, and allow the investor to earn an overall return on a regular basis, the asset may be worth keeping for a number of years before selling it at a profit.
