A:

Essentially, the effective annual return accounts for intra-year compounding, and the stated annual return does not.

The difference between these two measures is best illustrated with an example. Suppose the stated annual interest rate on a savings account is 10%, and say you put $1,000 into this savings account. After one year, your money would grow to $1,100. But, if the account has a quarterly compounding feature, your effective rate of return will be higher than 10%. After the first quarter, or first three months, your savings would grow to $1,025. Then, in the second quarter, the effect of compounding would become apparent: you would receive another $25 in interest on the original $1,000, but you would also receive an additional $0.63 from the $25 that was paid after the first quarter. In other words, the interest earned in each quarter will increase the interest earned in subsequent quarters. By the end of the year, the power of quarterly compounding would give you a total of $1,103.80. So, although the stated annual interest rate is 10%, because of quarterly compounding, the effective rate of return is 10.38%.

That difference of 0.38% may appear insignificant, but it can be huge when you're dealing with large numbers. 0.38% of $100,000 is $380! Another thing to consider is that compounding does not necessarily occur quarterly, or only four times a year, as it does in the example above. There are accounts that compound monthly, and even some that compound daily. And, as our example showed, the frequency with which interest is paid will have an effect on effective rate of return.

(To read more, see Projected Returns: Honing The Craft.)

RELATED FAQS

  1. How do you calculate GDP with the income approach?

    Learn how to calculate the gross domestic product (GDP) of a country by using the income approach, which adds together all ...
  2. What is the difference between earnings and income?

    See how earnings and income are different and when they are used in relation to personal finance versus a business' financial ...
  3. What is the formula for calculating beta?

    Find out more about beta, what a stock's or portfolio's beta measures, and learn how to calculate a security's or portfolio's ...
  4. How can I use a regression to see the correlation between prices and interest rates?

    Learn how to use linear regression to calculate the correlation between stock prices and interest rates by taking the square ...
RELATED TERMS
  1. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
  2. Compound Annual Growth Rate - CAGR

    The year-over-year growth rate of an investment over a specified ...
  3. Mean-Variance Analysis

    The process of weighing risk against expected return. Mean variance ...
  4. Systematic Sampling

    A type of probability sampling method in which sample members ...
  5. Variance

    The spread between numbers in a data set, measuring Variance ...
  6. Leptokurtic

    A statistical distribution where the points along the X-axis ...

You May Also Like

Related Articles
  1. Technical Indicators

    What's the difference between Bollinger ...

  2. Active Trading Fundamentals

    Tracking Volatility: How The VIX Is ...

  3. Stock Analysis

    Small Cap Permian Players To Watch

  4. Stock Analysis

    Nexen And The Horn River Shale

  5. Stock Analysis

    ConocoPhillips Is A Strong Buy

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!