Tempted in early January by the rising price, you buy at 300 and watch your wealth grow as the price rises to 400 – only to see it plummet throughout the Spring. Now your investment is worth less than you paid for it. Then it improves. Then it crashes again in June.
Clearly, paying too much attention to price charts like this one could encourage a short-term trading mentality which distracts you from long term investment goals.
What is the answer? When you’re pursuing long term investment goals you need to think in terms of an asset’s average annual returns.
In finance, return is the profit – in the form of income and capital appreciation – on an investment. The rate of return is a percentage which measures the rate of gain or loss of an investment over a given holding period. Gains or losses are measured by positive or negative rates of return respectively. Average annual returns are simply the average of these returns over the course of a year.
The average annual return of an asset (or of an asset class) gives you a figure for performance across time with which you can start making sensible comparisons between different investments. This will help to guide your asset allocation process (choosing where to put your money) and it will let you gauge your resulting portfolio performance in a meaningful time frame.
So now you can easily compare a share’s returns against, for example, a money market account, not just over one year, but over any time frame you choose to look at.
