What is the difference between stated annual return and effective annual return?

By Investopedia Staff AAA
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 I calculate the adjusted closing price for a stock?

    When trading is done for the day on a recognized exchange, all stocks are priced at close. The price that is quoted at the ...
  2. What are the odds of getting a perfect bracket in Warren Buffett's $1 billion March ...

    In 2014, Warren Buffett announced that he would give whoever could correctly guess every game of the NCAA men's basketball ...
  3. What's the difference between Bollinger Bands® and Keltner Channels?

    In technical analysis, there is a small difference between Keltner Channels and Bollinger Bands®. We'll explain it for you ...
  4. What is the difference between weighted average shares outstanding and basic weighted ...

    Outstanding shares refers to stock that is currently held by investors, including shares held by the public, and restricted ...
RELATED TERMS
  1. Compound Annual Growth Rate - CAGR

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

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

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

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

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

    A type of statistical distribution where the points along the ...
comments powered by Disqus
Related Articles
  1. How To Lie With Financial Statistics ...
    Fundamental Analysis

    How To Lie With Financial Statistics ...

  2. What Are The Odds Of Scoring A Winning ...
    Investing Basics

    What Are The Odds Of Scoring A Winning ...

  3. Breaking Down The Geometric Mean
    Investing Basics

    Breaking Down The Geometric Mean

  4. Accelerating Returns With Continuous ...
    Bonds & Fixed Income

    Accelerating Returns With Continuous ...

  5. Calculating Covariance For Stocks
    Fundamental Analysis

    Calculating Covariance For Stocks

Trading Center