≈ An apples-to-apples comparison. ≈
There are all sorts of metrics swirling around the Street. Becoming a top-notch trader requires learning all kinds of new ratios and definitions to understand better how to measure investment performance. One such formula that you’ll see again and again is the annualized return.
Did you ever wonder why interest rates are always quoted on an annualized basis? If the yield on your bank account is 0.25%, then that is what you get paid in interest over one year. If the interest rate on your mortgage is 3%, then that is what you are paying in interest on your loan over one year. The inflation rate is stated in annualized terms too. For example, the long-term historical inflation rate for the U.S. is 3%. This is because the cost of goods has risen by 3% on average per year over the past century.
The benefit of stating everything in annualized terms is that it makes comparisons easy. For example, if I’m shopping for the best high yield savings account and choice A pays 0.25% while choice B pays 0.45%, I know choice B is better. And I don’t have to do any math because the numbers are already stated in equal terms.
Sometimes you’ll see traders annualize their rate of return. Here’s an example. Suppose you built a covered call trade and made 2% over one month. Would it be fair to compare that 2% return to someone else’s investment that made 10% over one year?
No, it wouldn’t because they’re not stated in like terms. You’re comparing apples to oranges. So, annualize the covered call return. If you’re making 2% over one month, and you duplicated that every month, then you would capture 24% over the entire year. That is your annualized return.
Thus, making 2% over a month is better than making 10% over a year. Because the duration of each trade may vary, intelligent investors often annualize the returns for each so they can better compare performance.
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