The average return is the straightforward mathematical average of a series of returns over a specified period. It is calculated similarly to a simple average for any set of numbers. Add the figures together, then divide by the number of data points.
Key Insights
- Average return helps in evaluating the past performance of a security or a portfolio.
- It differs from annualized return as it does not consider compounding effects.
- In comparison, the geometric average is generally lower than the average return.
Grasping the Average Return
Various methods exist to calculate returns. For arithmetic average return, sum the returns and divide by the number of data points.
Average Return = (Sum of Returns) / (Number of Returns)
The average return gives an investor a basic snapshot of historical returns for a stock or security. However, it does not consider compounding.
Real-Life Example
Consider an investment with annual returns of 10%, 15%, 10%, 0%, and 5% over five years. Adding these returns and dividing by 5 yields an average return of 8%.
For example, suppose Walmart yielded the following annual returns over five years:
- 2014: 9.1%
- 2015: -28.6%
- 2016: 12.8%
- 2017: 42.9%
- 2018: -5.7%
To find the average return, sum these values and divide by 5:
((9.1 - 28.6 + 12.8 + 42.9 - 5.7) / 5 = 6.1%)
Calculating Returns From Growth
The simple growth rate reflects the ratio of beginning and ending balance, subtracted by one.
Growth Rate = (Ending Value - Beginning Value) / Beginning Value
Example: Assume you invest $10,000. If the stock price doubles from $50 to $100, then Growth Rate = (100 - 50) / 50 = 100%, leading to an investment portfolio of $20,000.
While straightforward, the simple average of returns may fall short in accuracy. For better precision, analysts prefer geometric mean or money-weighted rate of return.
Enhanced Metrics: Alternatives to Average Return
Geometric Average
Utilizing the geometric average offers improved precision. It eliminates the need for the actual amounts invested, facilitating performance comparisons across multiple periods. Often termed “time-weighted rate of return,” it accounts for inflows and outflows, removing growth rate distortions.
Money-Weighted Rate of Return (MWRR)
The MWRR includes cash flow size and timing impacts, offering effective portfolio return measurement inclusive of deposits, reinvestments, or withdrawals. Comparable to the internal rate of return (IRR), it ensures the net present value equals zero.
Related Terms: arithmetic mean, geometric mean, money-weighted return, internal rate of return.
References
Get ready to put your knowledge to the test with this intriguing quiz!
---
primaryColor: 'rgb(121, 82, 179)'
secondaryColor: '#DDDDDD'
textColor: black
shuffle_questions: true
---
## What is "average return" typically used to measure in finance?
- [ ] The highest possible return of an investment
- [x] The mean value of returns earned over a period
- [ ] The lowest possible return of an investment
- [ ] The risk associated with an investment
## What does the average return help investors estimate?
- [x] The expected performance of their investments over time
- [ ] The tax liability of their investments
- [ ] The exact future returns of their investments
- [ ] The exact purchase price of their investments
## How is average return typically calculated?
- [ ] By summing the returns and dividing by the time horizon length
- [x] By summing the periodic returns and then dividing by the number of periods
- [ ] By identifying the highest return and factoring for compounding
- [ ] By using the net present value (NPV) formula
## Which of the following is NOT a method for calculating average return?
- [ ] Arithmetic mean
- [ ] Geometric mean
- [x] Regression analysis
- [ ] Harmonic mean
## When comparing the geometric and arithmetic average returns, which is typically smaller for volatile investments?
- [x] Geometric average return
- [ ] Arithmetic average return
- [ ] Both are typically the same
- [ ] Neither, it can't be determined
## Why is the geometric average favored over arithmetic average for multi-period returns?
- [ ] It is simpler to calculate
- [x] It accounts for compounding over time
- [ ] It typically shows higher returns
- [ ] It minimizes transaction costs
## What can be a potential downside of relying solely on average return for investment decisions?
- [ ] It provides too much detail about the investment
- [ ] It only considers qualitative factors
- [x] It ignores the variability and risk of returns
- [ ] It always underestimates actual returns
## In which scenario would an investor NOT prefer using geometric average return?
- [ ] Comparing historical investment performance
- [x] Calculating annualized returns for non-compounding interests
- [ ] Evaluating portfolio performance over time
- [ ] Assessing the performance of volatile investments
## What is likely to happen to the arithmetic average return if an investment experiences both significantly high and low returns?
- [ ] It stabilizes to an accurate measure of average performance
- [x] It gets skewed, often reflecting higher than actual performance
- [ ] It will be unaffected
- [ ] It decreases significantly
## Which concept closely relates to average return in financial performance analysis?
- [ ] Gross Domestic Product (GDP)
- [x] Expected Rate of Return
- [ ] Price-Earnings Ratio (P/E)
- [ ] Current Liabilities
