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Understanding Stock Portfolios


Portfolio size and Brokerage costs

Investors should be aware that brokerage costs affects their portfolio's performance

Investing in Stocks for Beginners - Portfolio size and Brokerage costs; picture of lots of stock brokers working in an office building placing orders for their clients investment portfolios while using the phone and computer

Investors new to the stock market can start with any dollar amount they like in building their investment portfolio (the dollar amount is known as capital). The only consideration is with respect to the cost of brokerage, which can be relatively expensive for purchasing small quantities of stock. While the amount of money that investors start with varies considerably, for the purpose of this article they will be categorized into three levels as follows:

Small investment:The investor starts with $1,000

Medium investment:The investor starts with $10,000

Large investment:The investor starts with $100,000

Most beginner investors who open a stock brokerage account will nowadays typically open an account with an online broker. The brokerage costs are generally around $7 to $10 per order.

Small investment

While it is generally better not to invest all of the initial investing capital at once (as the beginner will probably make some less than ideal investment decisions to begin with), with only $1,000 this is small enough that even if the investor made the wrong decision based on a lack of experience, any mistake is not going to be financially disastrous. In this case, the investor might as well invest the full $1,000 to start with.

The investor needs to make a decision as whether to buy stocks or funds.

With stocks it is generally better to diversify and buy around 10 stocks. However, with a $1,000 to start with this means the investor can only buy $100 worth of each stock. The problem here is that the brokerage for each stock is going to be around $10, which means that the upfront cost per stock is 10%, which is extremely high. This is not to say that the investor cannot buy stocks, but it is extremely expensive to start with, however there are no ongoing costs.

Investing in Stocks for Beginners - Portfolio size and Brokerage costs; picture of a financial newspaper showing the mutual funds prices for brokers to buy and sell the funds for a portfolio

Another approach for the investor to consider is to buy a fund or two rather than stocks. The funds can be mutual funds, closed-end funds or an exchange traded fund (ETF).

Mutual funds have a minimum initial investment which varies from fund to fund, but there are funds that have minimums of only a few hundred dollars. The investor will however be paying an annual management fee which again varies considerably, but can be as low as around 1%. A lot of funds will charge entry fees, but there are mutual funds that do not.

Thus, with a mutual fund there is an ongoing annual fee that the investor must pay (which usually is deducted from the dividends due). Compare this to stocks with the upfront 10%; the mutual fund will have an ongoing fee of say 1% per year (which adds up over the years). The investor will either pay the costs upfront as with stocks or pay the costs over the years as with funds. It should be noted that with both stocks and funds, the investor will receive any dividends due.

The investor might also consider buying an ETF. While there is still a brokerage cost of say $10, it is for the purchase of $1,000 of an ETF, thus the effective upfront cost is only 1% instead of 10% for the stocks. The investor still has the annual management fee for the ETF, but this is generally cheaper than with mutual funds and may be less than 0.5% for an index tracking fund.

Medium investment

The investor with $10,000 to start with might considerer not to invest the entire amount to begin with, but rather start with only a portion of the total and build up their portfolio over a period of time. This is entirely up to the investor and whether the investor plans on contributing more funds on an ongoing basis. The main point here is that investing is a skill that is developed with experience and knowledge and as the investor's experience increases they will typically want to buy more stocks (which they cannot do if there are no funds remaining).

Investors often feel that they must invest their

entire account when they first start investing

The medium sized investor is in a better position as far as relative brokerage costs are concerned. Let's assume that the investor decides to start with $5,000 for now and decides to buy a diversified portfolio of 10 stocks.

Each stock purchase will be $500 and with a brokerage of $10 gives an upfront cost of 2%. This is quite respectable and the investor has no ongoing costs and will receive any dividends due.

The investor still has the option of buying mutual funds. The investor might consider buying a closed-end fund or an ETF. Buying $5,000 of a fund with a $10 brokerage gives an effective upfront cost of only 0.2%. However, it is probably better to buy several funds rather than put all the capital into only one fund. That way the investor could buy a growth investing fund and an index fund for example.

Investing in Stocks for Beginners - Portfolio size and Brokerage costs; picture of a stock broker sitting at a desk while using a computer to check the portfolio and brokerage costs for their clients

Large investment

The investor starting with $100,000 is probably keen and enthusiastic about making money from the stock market. They are well capitalized and inexperienced, and this is a dangerous combination.

If the small investor loses 20%, their portfolio is only down $200. However, the large investor's portfolio will be worth $20,000 less, which is now financially really noticeable. This puts the large investor under considerable financial pressure and due to their inexperience they will likely make all sorts of silly and illogical decisions in an attempt to try and recoup the lost value in their portfolio. Making investment decisions while emotionally distressed is self destructive and is a fantastic way of totally destroying the value in ones portfolio.

Most professional stock investors would indeed recommend that the large investor start off with only a portion of their available capital. Many of these professional stock investors are talking from bitter experience and the mistakes they made in their early days of investing.

The large investor might consider starting with only 25% invested in stocks and over the coming months or even years gradually increase their stock portfolio size. Investors tend to gain experience fairly quickly as capital gains are a great motivator for increasing their knowledge base. This increased knowledge leads to wiser investment decisions, which in turn leads to further capital gains. Thus, knowledge and experience, and profits are all interconnected.

The large investor might start with $25,000 and buy 10 stocks. Each stock purchase would be $2,500 and with a brokerage of $10 gives an upfront cost of only 0.4%. This is very cost effective and the investor has no ongoing costs and will also receive any dividends due.

Of course the large investor can also consider buying funds. Some stock investors will buy stocks and funds, especially index funds, foreign stock market funds or bond funds. Investors with a large amount of capital can more readily and economically spread their investments across various markets.

While investment capital is not a barrier to investing in the stock market, the investor needs to consider their available capital and decide on the most appropriate approach to take.

Order Types and Features

Investing in Stocks for Beginners - Order Types and Features; picture of a stock broker instructing other brokers to use various order types while using the phone and the computer

The variety of order types and features available to investors continues to increase as technology advances. Long gone are the days where the only order types available were a market order or a limit order.

Nowadays investors can effortlessly place complex order setups directly to an electronic exchange and all that is needed is an internet connection. In fact the investor does not even need to use their computer as they can simply use their smart phone.

As the order types and features continue to increase it is a good idea that investors keep up with the latest that's on offer.

While not all brokers will offer all of the order types and features listed in this article and some brokers have different names for the order types and features, the following provides an overview on what the brokers are generally offering investors these days.

Accumulate/Distribute

This is an order type where the investor can easily break up a larger order into a sequence of smaller orders. Rather entering a sequence of smaller orders one after the other, the investor can essentially set the order system to periodically enter small orders at a set interval. For this order type accumulate means to buy stock and distribute means to sell stock.

As an example, the investor may wish to buy (accumulate) 1,000 shares in a fairly illiquid stock that does not have that share quantity immediately available. The investor can set the order system so that it places a limit order for say 100 shares. When this 100 share order is filled, the system can be set to wait a specified time such as 5 minutes before the next 100 share limit order is placed. The order system will continue to this automatically until the 1,000 share order is completely filled.

All or None (AON)

The All or None (AON) is an attribute that can be added to a limit order. Most investors who use limit orders will at some stage have had their order only partially filled. The AON feature eliminates partial order fills. The order is only executed if the order share quantity can be completely filled, otherwise the order remains inactive.

Bracket

This order type can have numerous different names and is simply a combination of orders - an entry order combined with a stop-loss order and a profit target order.

After placing a Bracket buy order that has filled the order system automatically:

  1. Places a stop-loss sell order at a preset offset amount below the current market price
  2. Places a profit target limit sell order at a preset offset amount above the current market price.

The offset amount is specified at the time the Bracket order is placed.

Conditional

This feature allows the investor to add conditions that must be satisfied before the order can be executed.

As an example, an investor is looking to buy a breakout from a trading range but only wants to do so if the S&P 500 index is trading above a certain amount and the price of Crude Oil is trading above a certain amount.

With this feature the investor can specify the conditions that need to be satisfied before the buy order can be executed.

Discretionary

A Discretionary order is an attribute that is added to a limit order to increase the price range that the order can be executed.

As an example, in a fast moving market a stock might have an asking price of 30.50. The investor places a limit buy order for 30.50 but due to the fast moving market the Ask price may increase again by the time the investor clicks the send button. The discretionary attribute is a feature that adds a preset amount to the limit price (say 0.10) which means that the limit price is increased to 30.60 when it reaches the exchange. If the Ask price is less than or equal to 30.60 then the order is filled. If the Ask price has risen above 30.60 then the order is placed in the order book at the original limit price of 30.50.

Fill or Kill (FOK)

The Fill or Kill (FOK) attribute is a time feature for limit orders where if the order cannot be immediately executed then the order is canceled.

The FOK attribute is similar to the All or None (AON) attribute but they are not the same.

Once the investor submits an FOK limit buy order, if the share quantity cannot be immediately filled then the order is canceled. With the AON attribute the order remains inactive at the exchange and is not canceled.

Good after Time/Date (GAT)

This is a time attribute that can be added to an order. Essentially this feature delays the activation of the order until the specified start time and date.

An investor might place a market order to buy stock before they go to work at say 8:00 AM EST. Some investors do not want their orders executing at the market open due to the wide Bid/Ask spreads. By specifying the start time and date then the order will not execute until that time and date. The investor can specify a start time of say 10:30 AM EST and a start date of Today.

Good til Time/Date (GTD)

This is a time attribute that can be added to an order. Essentially this feature terminates an unfilled order after the specified start time and date.

This attribute allows an investor to set a time and date at which the order will be canceled - even if the order is only partially filled.

For example an investor may wish to sell a stock with a limit price but the stock is going ex-dividend. If the investor cannot sell their stock at the limit price before the ex-dividend date, then the investor wants the order canceled. The Good til Date can be set as the day before the ex-dividend date and time can be left blank - which will default to the market close.

Good til Canceled (GTC)

This time attribute is commonly used nowadays which allows the order to continue working beyond the day that the order is placed.

A lot of brokers now offer an option as to whether the order is a day only order or not. The GTC attribute is used if the investor wants to be sure that the order continues working past the day it was entered.

Immediate or Cancel (IOC)

The Immediate or Cancel (IOC) attribute can be attached to a limit order. Any portion of the order that is not immediately filled when the order is placed will be canceled.

As an example, if the investor places a limit buy order for 100 shares and only 60 shares fill immediately at the limit price, the order for the remaining 40 shares is canceled.

Limit if Touched (LIT)

The Limit if Touched (LIT) order is essentially a limit order with a trigger price attribute.

When an investor uses a LIT buy order, they set the limit price as normal and they set a trigger price which is below the current Ask price. The trigger price must be above the limit price.

As an example, an investor places a LIT buy order with a limit price of 20.00 and a trigger price of 20.10 when the Ask is 20.50. The limit order is only placed in the order book if the Asking price drops down to 20.10 (otherwise the limit order is not placed).

Limit on Close (LOC)

The Limit on Close (LOC) is a limit order that is only activated at the market close.

A LOC buy order will only fill if the Asking price at the close is at or lower than the limit price. Any unfilled quantity is canceled.

This order type is useful for trading strategies that use the closing price.

Limit on Open (LOO)

The Limit on Open (LOO) is a limit order that is only activated at the market open.

A LOO buy order will only fill if the Asking price at the open is at or lower than the limit price. Any unfilled quantity is immediately canceled. The order does not remain active after the open.

Market on Close (MOC)

The Market on Close (MOC) is a market order that is only activated at the market close. The investor is not guaranteed to receive the exact same price as the last price before their order was submitted. The investor's order may have created a new closing price but with actively traded stocks this is likely to be only a few cents difference.

This order type is useful for trading strategies that use the closing price.

Market on Open (MOO)

The Market on Open (MOO) is a market order that is only activated at the market open. The investor is not guaranteed to receive the exact same price as the open price. The investor's order might take the next ask price available. The MOO may give a price that is different from the open price or the MOO may create the open price with the investor's own order. At least the investor will have their order filled at the open.

One Cancels All (OCA)

The One Cancels All (OCA) is actually a group of orders linked together. When one order in the group is filled then the other orders are canceled.

This order grouping is frequently used when an investor is looking at say three stocks to buy on the day but only has funds to buy one stock. The investor can place an OCA group with a limit order for all three stocks. When the first limit order is filled then the other two limit orders are canceled.

Investing in Stocks for Beginners - Stock Ownership methods; picture of old original share certificate that was commonly used in the last century next to an old clock

Stock

Ownership

methods

Your ownership type is determined by your investing status

Most stock investors are under the impression that when they buy a stock that their name will appear on the company's books as a registered owner of those shares. This may or may not be the case, as it depends on the method that use used to acquire those shares.

There are actually three methods that are used to record the ownership of a company's shares and they are Physical Certificate, Brokerage Firm Registration and Direct Registration.

Physical Certificate

With this method, the investor's name is recorded on the company's books as a stockholder. This is the oldest and original method used. When an investor places an order to buy stock with their broker and that order is filled, the stock purchase is settled three days later and the investor's name is listed on the company's books and the investor receives a certificate of ownership for that stock. The same applies if stock is acquired directly from the company through a stock purchase plan.

The investor will receive company reports such as annual reports mailed directly to them and dividends will be paid to the investor directly from the company. The investor is also responsible for notifying the company of any change of address.

If the investor wants to sell their stock, they first need to send their certificate to the stock broker who sights this as evidence that the investor actually owns the stock. Thus, the investor can not immediately sell their stock as it takes time for the broker to receive the certificate.

Brokerage Firm Registration

This is the modern method used by online brokers, although non-online brokers may also use this method of stockholder registration. With this method, when an investor buys stock, it is actually settled in the broker's name, not the investor's name. Thus it is the broker's name that appears on the company's books as the registered stockholder, not the investor. The investor's name only appears on the brokers books as the owner of those shares. As a broker can have many investors owning stock on their books in the same company, the broker must keep track of the individual investors who actually own those particular shares.

Most retail investors will own their stock

with Brokerage Firm Registration

The investor will not receive any company reports or any other communication directly from the company as the company is not aware of the investor. Instead the company sends any communications directly to the broker. In turn the broker relays this information to the investors that are on the broker's books for that stock.

Dividends are actually paid to the broker as they are on the company's books as a stockholder. The broker in turn allocates the per share dividend payment to each investor's account.

If the investor wants to sell their stock, they simply need to instruct their broker to place a sell order which can be done by phone or over the internet if using an online broker. There is no certificate proof of ownership issues to content with and there is no time delay in placing a sell order place.

Direct Registration System

This is basically a combination of the physical certificate method and the broker firm registration method.

With the direct registration system (DRS) the investor's shares are directly recorded on the company's books using an electronic system. No physical certificate is issued, but the investor still receives direct communications from the company such as annual reports. Also, dividends are paid directly to the investor by the company.

If the investor decides to sell their stock, the investor instructs their broker who electronically transfers the shares from the company's books across to the broker's books. Once the broker has confirmation that it has received those shares, the broker will place the order to sell those shares.

It should be noted that a broker will only place an order to sell shares when the broker has physically confirmed that those shares actually exist. Hence the need to transfer the shares across to the broker.

The difference with DRS and the physical certificate method is that DRS transfers the shares electronically rather than having to hand the broker a paper certificate.

Summing up

The investor does not necessarily have a chose in which stock registration method to use as this depends on the stock broker. Generally, it is the institutional investors and high net wealth investors that tend to favor the physical certificate or DRS methods.

For the typical stock investor, the broker registration method is often the only choice if using an online broker and for the most part this method is the most appropriate as the investor can immediately place a sell order and the investor need not worry about keeping the contact details up to date.

Stock Repurchases

Investing in Stocks for Beginners - stock repurchases picture of a financial newspaper with the business section and a pie chart printed on paper next to a calculator

Stock buybacks can increase shareholder value

When a company makes a profit, management has the choice of paying this profit to their stockholders as a dividend or to keep the profit within the company as retained earnings.

Management may also pay some of the profit via a dividend and retain the remainder on its balance sheet. The dividend payout ratio is the proportion of the profit that is paid as a dividend.

Any profit that is not paid out as a dividend is recorded on the balance sheet under the stockholders' equity section as retained earnings. The retained earnings can accumulate over the years and the company can use this money for other purposes such as to acquire other companies, to reduce debt or to buy back its own shares.

Companies often reduce the amount of retained earnings when they become too large. This is to make the company less attractive as a take over target - since companies with lots of cash on balance sheet are prime takeover targets.

Treasury Stock

When a company buys back its own shares, the company can either cancel those shares or hold them for future reissue. When a company holds these shares rather than canceling them, those shares are referred to as treasury stock and they still exist but they are not owned by anyone.

When a company initially floated as a public company (known as an Initial Public Offering or IPO), the company issued a set number of shares. These initial shares are referred to as Shares issued. After the company buys back some of its Shares issued, the remaining shares are referred to as shares outstanding.

Shares outstanding = Shares issued - Share buyback

As an example, a company issued 10,000,000 shares and bought back 1,000,000 shares but did not cancel those shares.

Shares outstanding = 10,000,000 - 1,000,000 = 9,000,000 shares

Treasury stock = 1,000,000 shares

If the company cancels the shares it bought then the treasury stock will be zero.

If the company has treasury stock, this is shown on the balance sheet as a negative dollar value in the stockholders' equity section. The negative value reflects the dollar amount the company paid for those shares. If the company cancels the shares it bought then the retained earnings is reduced by the amount paid for those shares.

Investing in Stocks for Beginners - stock repurchases; picture of an investor holding a clipboard and pen in his hand while studying the stock chart data displayed on a large wall panel

Treasury stock does not receive dividends as a company cannot pay itself a dividend. Should the company pay a dividend, the dividend pool is divided up amongst the shares outstanding - which effectively increase the dividend paid per share. Also treasury stock does not carry any voting rights as they are not owned by anyone.

Treasury stock can also arise during the IPO as companies may not sell of the shares issued. The company can keep a certain number of issued shares and in the future if the company needs to raise extra cash they can simply sell the remaining issued shares. Otherwise the company would have to issue new stock in the future which will incur additional costs. Thus having treasury stock is a cost effective way to raise capital in the future if needed.

Stock Repurchases

The main purpose of a company buying back its own shares is to reduce the number of shares outstanding. The effect this has is to increase the dividends per share and the earnings per share since for the same profit there are fewer shares.

Share buybacks are a tax effective way to boost the stock price since the stock price generally follows the earnings per share rather than the profit.

When the stock price is undervalued, the company may offer a premium above the current stock price. This sends a signal to investors that management considers the stock price too cheap and that the stock is worth more than what the market is currently is paying. This is a cost efficient way of reducing the shares outstanding.

Companies that buy back their shares when the stock price is high can provide investors with confidence that stock price still has further to climb.

While stock repurchases benefit the dividends per share and the earnings per share, they have no effect on the company's book value (stockholders' equity). This is because cash is used from the retained earnings to pay for the shares - while there are fewer shares outstanding, the net assets is also reduced. This is best illustrated with an example.

As an example, a company has Net assets of $100,000,000, Earnings of $10,000,000, Shares outstanding 10,000,000. The company buys back 1,000,000 shares at $10 a shares.

Before stock repurchase

Book value = 100,000,000 / 10,000,000 = $10.00

EPS = 10,000,000 / 10,000,000 = $1.00

After stock repurchase

Buyback cost = 1,000,000 x 10 = $10,000,000

Shares outstanding = 10,000,000 - 1,000,000 = 9,000,000

Net assets = 100,000,000 - 10,000,000 = $90,000,000

Book value = 90,000,000 / 9,000,000 = $10.00

EPS = 10,000,000 / 9,000,000 = $1.11

Thus buying back 10% of the issued shares increases the earnings per share by 11% but the book value remains unchanged.

Another consideration with shares outstanding is when a company has convertible instruments such as convertible bonds or company issued stock options. Should these be exercised then the number of shares outstanding is increased. The term 'diluted shares outstanding' is used to allow for the maximum number of shares outstanding if all the convertible instruments were exercised.

Profit Taking

When the market participants lock in a quick profit

Investing in Stocks for Beginners - profit taking; picture of a stock investor pointing at the top of a chart displayed on a glass panel floating in front of him using his index finger

The term profit taking is frequently mentioned in the financial press and it may seem fairly obvious as to what they are referring to. It's usually mentioned whenever a stock, commodity or currency has had a quick gain and prices then pullback. The presumption is that market participants are now selling in order to lock in a profit from the quick price gain.

In reality Profit taking occurs all of the time and also occurs from short sellers when market prices have a quick decline - which the financial press never refers to as 'short selling profit taking'?

Short-term traders, speculators and investors are taking profits all the time, which includes selling into a rally with a profit target. This especially occurs when market participants use chart patterns with profit targets and they place limit sell orders.

In fact there are always buyers and sellers present in the market place - after all, it's the buyers who buy stock from the sellers (if nobody is selling then a buyer cannot buy).

The general implication (by the financial press) is that profit taking is something that only occurs after a price increase and the subsequent pullback is only temporary.

The market price is a never ending sequence of short-term rallies and short-term pullbacks and follows the principle of supply and demand. During a rally there is more demand form buyers than there is supply from sellers. The opposite occurs during a pullback where there is less demand form buyers than there is supply from sellers. Thus any pullback can be though of as profit taking from long sided market participants.

Profit taking is only a temporary decline and after the pullback is completed the stock then rallies again. If the rally continues above the high of the previous rally then the trend is still upwards. However if the next rally falls short and does not reach the previous rally's high before selling off again and trades below previous pullback's low, then the trend may have reversed and a new downtrend started. A second lower pullback is not called profit taking as it is only the first pullback that is called profit taking.

Profit taking can lead to a trend reversal,

due to fear that prices may have peaked

So why are these market participants taking profits? Basically any market participant who has an open profit and they are concerned that the price advance has peaked will likely be a seller. The reasons for their concern are wide and varied and actually do not matter. If a market participant is worried that they will lose their open profit they will probably sell to lock in that profit rather than risk losing it. Greed and fear is what drives the market.

When the price advance is only minor then it's mostly the short-term participants such as swing traders and position traders who are profit taking - usually the price has reached their profit target or when prices pullback then their trailing stop-loss is triggered.

If the price has made a more significant advance, then the speculative traders become more active with profit taking. While the short-term traders are also active they tend to sell their entire position, but the speculative traders and investors tend to only sell a portion of their holdings so as to lock in some profit just in case the last rally proved to be the top of the uptrend.

Annualized vs. Average Rate of Return

Investing in Stocks for Beginners - Annualized and Average Rate of Return; picture showing three stock investors sitting and standing on a very large animated stock chart against the wall

It's easy to get confused

In the financial markets it is common practice to state the returns from an investment as a percentage per year.

For example, the S&P 500 index returned 22% a year over the last four years. As another example, the S&P 500 index achieved an annualized return of 17% during the last four years.

In both cases the same S&P 500 values were used (850 to 1590 over four years) but yet there are two different percentage figures for the returns. The reason for this is that there are two different methods of calculating the annual percentage returns.

  1. Annualized rate of return: A formula is used to calculate the percentage figure for the gain over the number of years. With this method the percentage gain is the same for each year and the dollar amount increases each year. This method is also known as the compounding rate of return.
  2. Average rate of return: The total gain over the number of years is dividend by the number of years. With this method the dollar amount gained each year is assumed to be the same which means that the percentage return declines each year. This is a simplistic method which ignores the compounding effect on the return and this method is frequently used to calculate historical returns.

These two methods are best illustrated with a simple example as shown below in Table 1.

Table 1. Annualized vs. Average rate of return

annualized-average-return table

From Table 1. above, both methods start with $10,000 and end with $20,000 over a ten year period.

The annualized return is 7.18% per year and is calculated as follows.

Annualized rate of return = (($20,000/$10,000) ^ (1/10yrs) - 1) x 100% = 7.18% per year

The average rate of return is 10% per year and is calculated as follows.

Percentage gain = ($20,000 - $10,000) / $10,000 x 100% = 100%

Average rate of return = 100% / 10 yrs = 10% per year

The average rate of return is an easy calculation to perform and is a common method for stating the annual percentage returns. In fact if no other reference is made to the returns, then assume the returns were calculated using the average rate of return method.

The average rate of return method in effect calculates an average percentage gain and applies that percentage to work out the dollar gain for the first year (which for the above example is $1,000 based on 10%). This dollar amount is then simply added to each year (which leads to a declining percentage gain per year).

This is in contrast to the annualized method which adds a fixed percentage to each year, thus the dollar amount gained each year actually increases. Over the long-term, the stock market actually follows a compounding return rather than a fixed annual dollar gain such as obtained with the average rate of return - it's just that it is easier to calculate the percentage for the Simple rate of return.

The long-term effect can be readily observed with very long-term line charts (20 years and more). With a linear price scale the plotted data tends to bow upwards rather than showing a straight line. This is referred to as an exponential graph and is the reason why charting packages provide a log scale feature - which is intended for long-term charts.

The example for the annualized and vverage rate of returns shown in Table 1. are plotted on a graph as shown below.

Graph 1. Annualized vs. Average rate of return

annualized-average-return graph

As can be seen from the above graph, the average rate of return plots as a straight line and the annualized return plots as an exponential curve.

For the same capital gain the average rate of return is always a higher percentage figure, which in this example is 10% (the annualized return is 7.18%).

The annualized method is normally used when the long-term compounding effect needs to be taken into account. Over the shorter term there is little difference between the two methods. As the time frame increases the difference becomes more noticeable. In reality, the average rate of return is frequently used as it is a quick and easy calculation to perform, while calculating the annualized return requires either a financial calculator or a spreadsheet application.