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.)

  1. Is Colombia an emerging market economy?

    Colombia meets the criteria of an emerging market economy. The South American country has a much lower gross domestic product, ... Read Full Answer >>
  2. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  3. What are some of the more common types of regressions investors can use?

    The most common types of regression an investor can use are linear regressions and multiple linear regressions. Regressions ... Read Full Answer >>
  4. What types of assets lower portfolio variance?

    Assets that have a negative correlation with each other reduce portfolio variance. Variance is one measure of the volatility ... Read Full Answer >>
  5. When is it better to use systematic over simple random sampling?

    Under simple random sampling, a sample of items is chosen randomly from a population, and each item has an equal probability ... Read Full Answer >>
  6. What are some common financial sampling methods?

    There are two areas in finance where sampling is very important: hypothesis testing and auditing. The type of sampling methods ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  2. Investing

    What is Descriptive Statistics?

    Descriptive statistics is the term applied to meaningful data analysis.
  3. Fundamental Analysis

    Create a Monte Carlo Simulation Using Excel

    How to apply the Monte Carlo Simulation principles to a game of dice using Microsoft Excel.
  4. Mutual Funds & ETFs

    Top 4 Inverse Equities ETFs

    Explore analysis of some of the most popular inverse and leveraged-inverse ETFs that track equity indexes, and learn about the suitability of these ETFs.
  5. Forex Fundamentals

    How Foreign Exchange Affects Mergers and Acquisitions Deals

    Learn how foreign exchange rates can impact the flows of international merger and acquisition (M&A) transactions, and understand how deals can impact exchange rates.
  6. Mutual Funds & ETFs

    Finding Lower Risk, Higher Return Mutual Funds

    Discover detailed analysis of lower-risk, higher-return balanced mutual funds, and learn about the characteristics of this type of mutual fund.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares Globl Consumer Discretionary

    Explore analysis of the iShares Global Consumer Discretionary ETF, and learn about the suitability of this fund that tracks the consumer discretionary sector.
  8. Mutual Funds & ETFs

    Top 4 Muni New York Mutual Funds

    Explore detailed analyses of the top four New York municipal bond mutual funds, and learn the type of investor for which these funds are best suited.
  9. Mutual Funds & ETFs

    3 Mutual Funds That Hold Facebook Stock

    Explore detailed analysis of three mutual funds that include common stock of social media giant Facebook, Inc. in their top holdings.
  10. Professionals

    Career Advice: Financial Analyst Vs. Actuary

    Read an in-depth comparison between financial analysts and actuaries, what it's like to work as each and how to determine which is best for you.
  1. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  2. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  3. Linear Relationship

    A statistical term used to describe the directly proportional ...
  4. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  5. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
  6. Mean-Variance Analysis

    The process of weighing risk against expected return. Mean variance ...

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
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!