Who wouldn’t like to claim a 423,181 percent return in one day?
Earlier this year, one of my analysts logged a trade with an annualized gain of 423,181 percent. (That’s not a typo.)
Of course, he’s no billionaire just because of that trade.
But his trade raises a question people often have about “annualized gains.”
I frequently get questions on how people should view annualized returns. They can be badly misused and badly misunderstood. So why would an investor even care about them? I’ll explain below why you should care about them.
In simplest terms, annualized return calculates what would happen if you repeated a trade’s success over the course of a year. If you close a trade for a 10 percent gain over six months, you have a 20 percent annualized gain. The trading year is made up of two six-month periods. And two times a 10 percent nominal return equals a 20 percent annualized return.
This math makes sense. It lets us compare the success of various trades over various time frames. For example, if you make 50 percent on a trade in just two months, it’s better than making the same gain in two years.
But extreme “annualized return” examples can create absurd numbers and expectations.
Take a trader who buys a stock and sells it the next day for a 1 percent gain. That expert can claim an annualized gain of 252 percent. (The convention is to assume there are 252 trading days each year.)
And if you factor in the effect of compounding gains, the numbers get even bigger. Compounding returns refers to when one day’s gains are reinvested the next day, increasing the value of each subsequent day’s gain. If you calculate compounding returns, the trader can claim an annualized return of 1,127 percent.
A similar distortion resulted in my analyst’s eye-popping return: He recently closed a trade for a 114.29 percent gain in 23 days. Accounting for compounding returns, he can legitimately claim a six-figure annualized rate of return.
I think you can quickly tell this is unrealistic and probably impossible. Annualized gains may look good. But they don’t put any money in your pocket. You can’t buy anything with them.
Also remember, since you can’t lose more than 100 percent on most investments, a 1 percent loss in a single day comes out to an annualized loss of 92 percent. (If you shave 1 percent off the value of something every day, you’ll never reach zero. You simply end up cutting smaller and smaller pieces off a smaller and smaller pie.)
Compare that with the annualized gain of 1,127 percent, and you can see how adding up a bunch of annualized gains can quickly distort the truth.
If that’s the case, why use “annualized gains” at all?
Because annualized returns are a key tool for comparing the returns of investments with different timeframes.
Suppose I offer you the choice of two investments.
Investment A will return 4 percent in three months. Investment B will return 7 percent in five months. It’s clear that Investment B offers a higher return, but it will take longer to get it.
This is where using annualized gains can help. Investment A has an annualized return of 16.99 percent. Investment B has an annualized return of 17.63 percent. Investment B still offers the better return.
So what are the rules to annualized gains?
First, don’t take them as gospel if someone is trying to convince you of an investment or trading strategy. Second, the shorter the time period, the less useful annualized gains get. (Think about the one-day trade example.)
Again, to calculate your own annualized gains, you just need to do a little bit of simple math. Start with how long the trade will last (or lasted). Then, figure out how many of those time periods fit in a year. Finally, multiply the result by the gains.
So let’s say you have a trade that will close in three months. There are four three-month periods in a year. If the trade returns 10 percent, your annualized return is 40 percent (four times 10 percent).
Of course, as the saying goes, you can’t “eat” annualized returns. And you should always be skeptical if an annualized gain sounds outlandish.
But don’t dismiss them entirely. They’re a handy tool for comparing different trades.
Here’s to our health, wealth and a great retirement,
— Dr. David Eifrig
This article originally ran on Wednesday, Aug. 14, at DailyWealth.com.