Difference between Annual Return and Annualized Returns - A Conversation
I was just doing some research on returns and I realized that there's a difference between annual return and annualized return.
Below is a conversation between two friends Ganesh and Abbey. Abbey seeks Ganesh's help to understand the difference between Annual Return and Annualized Returns.
Ganesh: Hey Abbey, how's it going?
Abbey: Not bad, just thinking about my investments. How about you?
Ganesh: Same here. I was just doing some research on returns and I realized that there's a difference between annual return and annualized return.
Abbey: Really? I didn't know that. Can you explain it to me?
Ganesh: Sure. Annual return is the rate of return on an investment over one year. It's calculated by taking the change in value of an investment and dividing it by the original value, then multiplying by 100 to get a percentage.
Abbey: Okay, that makes sense. So what's annualized return then?
Ganesh: Annualized return is a way to compare returns from investments with different holding periods. It's calculated by taking the return of an investment over a certain period of time, then adjusting it to an annual rate.
Abbey: So it's like a way to compare apples to apples, even if the investments were held for different periods of time?
Ganesh: Exactly. For example, if you had an investment that returned 20% over 6 months, you can annualize that return to see what the equivalent return would be over a full year.
Abbey: That's really helpful. How do you calculate annualized return?
Ganesh: There are different ways to calculate annualized return, depending on the type of investment and the holding period. But one common method is to use the formula: ((1 + return)^(12/holding period)) - 1.
Abbey: That sounds a bit complicated. Can you give me an example?
Ganesh: Sure. Let's say you invested $1000 in a stock and after 6 months, the stock is worth $1200. The annual return would be 20%. But if you want to know what the annualized return would be if you held the stock for a full year, you would use the formula.
((1 + 0.2)^(12/6)) - 1 = ((1.2)^2) - 1 = 1.44 - 1 = 0.44
So, the annualized return would be 44%
Abbey: Wow, that's a big difference. I can see why it's important to know the annualized return.
Ganesh: Yes, it's a great way to compare different investments and make more informed decisions. But, it's also important to keep in mind that annualized returns are based on past performance and are not a guarantee of future results.
Abbey: That makes sense. Thanks for explaining it to me, Ganesh. I feel like I have a better understanding of how to evaluate my investments now.
Ganesh: My pleasure, always happy to help. But it's important to keep in mind that, annualized return is only one factor to consider when evaluating an investment, it's important to consider other factors such as risk and volatility.
Abbey: Yeah, I'll definitely take that into account. Thanks again for your help.
Ganesh: Anytime, happy to help.