Lesson

Annualized returns are calculated by taking the geometric average of the returns over a specified period and then converting it to an annual rate. This allows investors to compare the performance of investments with different holding periods.

Practice Question #1

Which of the following is NOT a factor in calculating annualized returns?

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Terms

Annualized return:
The return on an investment, expressed as a percentage, is calculated annually.

Practice Question #2

What is the primary purpose of calculating annualized returns?

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Do Not Confuse With

Time-weighted return:
A measure of an investment's performance that considers the timing and size of cash flows.
Dollar-weighted return:
A measure of the performance of an investment that considers the timing and size of cash flows, as well as the amount of money invested.
Simple return:
The return on an investment calculated without considering the effects of compounding.

Practice Question #3

Which method of calculating returns takes into account the compounding effect of returns?

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Historical Example

In the 1980s, a popular investment strategy was to invest in high-yield bonds, also known as "junk bonds." These bonds offered higher returns than traditional bonds but also carried higher risks. Investors who calculated the annualized returns of their junk bond investments were able to compare their performance to other investments, such as stocks and traditional bonds, and make informed decisions about their investment strategies.

Practice Question #4

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Real-World Example

An investor purchases a stock for $100 and sells it one year later for $120. The simple return on this investment is 20% (($120 - $100) / $100). However, if the investor had held the stock for two years and sold it for $144, the annualized return would be 20% as well.

Practice Question #5

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Formulas to Remember

Annualized Return = [(1 + Total Return)^(1/n) - 1] * 100 Where: - Total Return is the overall return on the investment - n is the number of years the investment was held

Practice Question #6

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Formula Examples

An investor purchased a stock for $100 and sold it after 3 years for $150. Calculate the annualized return. 1. Calculate the Total Return: ($150 - $100) / $100 = 0.5 or 50% 2. Calculate the Annualized Return: [(1 + 0.5)^(1/3) - 1] * 100 = 14.47% The annualized return is 14.47%.

Practice Question #7

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Pitfalls to Remember

Non-annual periods:
The formula assumes the investment period is in years. If the investment period is in months or days, convert it to years before using the formula.
Negative returns:
The formula may not accurately represent the annualized return for investments with negative returns.

Practice Question #8

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Practice Question #9

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