Categories

Investing

Tools

  • Economy & Politics
  • Investing
  • Personal Finance
  • Related Posts


    7 Big Companies Are About To Lose Money
    Good Riddance To Eric Holder
    Carl Icahn Wins Again: eBay To Spin Off PayPal; CEO John Donahoe Is Out
    A Day Of Global Economic Disappointments Is Just What The Stock Ramp Algo Ordered
    Europe, China Start Direct Trading In Euros, Yuan As De-Dollarization Expands
    Study Finds Treated Fracking Wastewater Still Too Toxic
    The Goldman Tapes And Why The Delusion Of Macro-Prudential Regulation Means The Next Crash Is Nigh
    Nobody Cares About Privacy, Not Even Criminals
    How American Parenting Is Killing The American Marriage
    Netflix Is Making An Original Movie—but It Won’t Come Cheap
    Drugstore Chain Walgreen’s Quarterly Sales Rise 6.2 Percent
    EBay Jumps In Premarket, To Spin Off PayPal
    EBay To Spin Off PayPal In 2015
    Euro Zone Inflation Slows In September, Weakens Euro Versus Dollar
    EU Says Ireland Tax Deal With Apple Was State Aid


    The Right Way to View ‘Annualized Gain’ Claims

    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.

    Dr. David Eifrig Jr. is the editor of two of Stansberry's best advisory services. One of his advisories, Retirement Millionaire, is a monthly letter showing readers how to live a millionaire lifestyle on less than you'd imagine possible. He travels around the U.S. looking for bargains, deals and great investment ideas. Already his average reader has saved $2,793 since 2008 (documented in each Retirement Millionaire issue). He also writes Retirement Trader, a bi-monthly advisory that explains simple techniques to make large, but very safe, gains in the stock and bond markets. This is a pure finance play and the reason Porter Stansberry loves having "Doc" on the team. Doc holds an MBA from Kellogg and has worked in arbitrage and trading groups with major Wall Street investment banks (Goldman Sachs). In 1995, he retired from the "Street," went to UNC-Chapel Hill for medical school and became an ophthalmologist. Now, in his latest "retirement," he joined Stansberry & Associates full-time to share with readers his experiences and ideas.

    | All posts from Dr. David Eifrig Jr.

    Discuss this Story:

    Comment Policy: We encourage open discussion. Comments including racist statements, profanity, name calling or spam will be removed at our discretion. We use filters for spam protection. If your comment does not appear it is likely because it violates the policy.

    Vanguard, BlackRock May Reap Billions From Pimco After Gross Exit
    Morningstar Strips Pimco Total Return Fund Of Its Gold Rating
    SoftBank, DreamWorks Animation Talks Have Cooled
    Stocks Head For Worst Quarter Since Euro Crisis, Dollar Reigns
    Strong Dollar, Rising Volatility Mark Third-quarter Markets. Same Again In Fourth Quarter?
    Ford Shares Plunge On Investor Day Bad News
    Bank Fined For Mortgage Processing Failures
    Bank Of America Paying $7.65M To U.S.
    Pimco Will Lose Billions From Gross’ Departure
    GM Ignition-switch Death Toll Rises To 23
    ‘Haters’ Lose $925M On 5 Despised Stocks
    Yahoo-AOL: No Guarantee Of Success
    Feds Look At New Toyota Acceleration Claims
    3 Stocks To Buy As Nation Faces The November Polls
    Stocks Tumble As High-Yield Credit Risk Spikes To 1-Year Highs
    Europe, US Stocks Slide: 10 Year Bid Back Under 2.50%
    New Global Crisis Imminent Due To ‘Poisonous Combination Of Record Debt And Slowing Growth,’ CEPR Report Warns
    Bank CEOs Are The New Drug Lords
    “I Am Putting Everything In Goldman Sachs Because These Guys Can Do Whatever The Hell They Want”
    The Bells Are Ringing… Are You Listening?
    The Plunge Protection Team Is Opening An HFT-Focused Chicago Office
    Apple And Google Make The Right Decision On Privacy
    Why Global Commodity Prices Are Crashing And What It Means For India
    Secret Tapes Update: Congressional Reaction, Goldman Changes Conflicts Policy
    Inside The New York Fed: Secret Recordings And A Culture Clash
    Oppenheimer Sees Near-term S&P Weakness, Would Buy On Dips
    Lloyds Bank Dismisses 8 Staff After Rate Rigging Probe
    Swiss Bank UBS Warns Of Penalties As Forex Settlement Talks Begin
    Dollar Is ‘Currency Of Choice’, Hong Kong Unrest Hits Stocks
    EU Watchdog To Give Reasons For Inquiry Into Apple’s Irish Tax Savings
    Read more from Investing...

    Liberty Investor Digest

    Get today's most important
    financial headlines all in
    one place by email!



    Sources


    close[X]

    Sign Up For Liberty Investor Digest™!

    Get Liberty Investor Digest FREE By Email!

    Input your name and email address in the fields below and get today's most important financial headlines sent straight to you inbox!

    Privacy PolicyYou can opt-out at any time. We protect your information like a mother hen. We will not sell or rent your email address to anyone for any reason.