Average Return: Meaning, Calculations, and Examples

The Average Return: What is it?

A sequence of returns generated over a period of time is averaged out using straightforward mathematics tactics and referred to as an average return. The same formula used to determine the simple average is used to determine an average return for any set of data. First, the sum is determined by adding all of the numbers together from the set. After that, the result is divided by the total number in the set.

The average return can be compared to a straightforward arithmetic mean. Consider the following investment returns as an example: 12%, 8%, 10%, 5%, and 20% yearly over a five-year period. In order to get the average return for the investment over these five years, the five-yearly returns are put together to add (sum), and then divided by 5. An annual average return of 11% is what it typically produces.

An investor or analyst can learn about historical returns for a company, investment, or portfolio of businesses by looking at the average return. Since compounding is not taken into account, the average return is different from an annualized return.

Comparison between Annualized Returns and Average Returns

As already said, average returns and annualized returns are not the same thing. Annualized returns are a popular metric among investors. Annualized returns are also known as geometric returns.

The annualized returns factor in volatility. Annualized returns typically mean an annual rate of return. What gets you from your beginning value to your ending value, regardless of what happens in between, is the annual rate of return.

The arithmetic mean of all annual returns may be thought of as the definition of average returns. Due to the annualized return's intrinsic smoothing, even in situations when the standard deviation is zero, average returns will frequently be higher. The difference between average returns and annualized returns would increase with increasing standard deviation.

Calculation of Average Return

Different return measurements can be calculated in different ways. Taken together, the returns are divided by the total number of returns to get the arithmetic average return. The formula to calculate the average return is as follows:

Average Return = Sum of the Returns/ Total No. of Returns

Calculation of Returns from Growth

The values or balances at the beginning and end determine the simple rate of growth. By dividing the result after deducting the end value from the start value by the start value itself, the growth rate can be calculated. Considering the meaning, we can conclude the following formula:

Growth Rate = [(BV-EV)/BV] *100

The beginning Value is denoted by BV, while the Ending Value is denoted by EV.

For instance, if you invest $10,000 in a firm and the stock price rises from $50 to $100, you may calculate your return by taking the gap between the two prices and dividing it by $50. The answer would be 100%. So, now you have $20,000.

A more precise approach is the geometrical average return when looking at historical return averages. Compared to the average return, the geometric mean/ average (money-weighted rate of return) is more consistent and accurate.

Advantages of Average Return

FlexibleTime Frame for Analysis

When calculating average return, an investor is free to choose any time frame. Every investor has a unique time horizon or the time frame within which they wish to sell their investment.

No Outliers

Outlying statistics are eliminated from data sets by the average return rate technique since it relies on averages. In the case of long-term averages, the impact of a single year of losses can be reduced by multiple years of profits. Since the projected rate of return merely averages the risk's actual effects on the investment's return, it only handles the risk implicitly, which is a problem with all investments. One-time occurrences that affect returns are less important to the amount of money an investment generates for its owners than gradual, consistent patterns.

Simple Comparison Method

The average rate of return method enables an easy comparison of different investment kinds.

Average Return's Constraints

The average return has a few drawbacks in spite of its popularity as a quick and accurate indicator of internal returns. The fact that various projects can call for various capital expenditures is not taken into consideration.

In the same spirit, it overlooks potential profit-reducing future costs and simply concentrates on anticipated cash flows from a capital infusion. Additionally, the average return makes the implicit assumption that future cash flows can be reinvested at rates that are comparable to the internal rates of return rather than taking into account the rate of reinvestment.

Given that the internal rate of return can occasionally produce a large amount and that the variables causing such return may be scarce or unavailable in the future, this assumption is unfeasible.

Examples of Average Return

Instances of average returns include the following:

Example 1

Assume you invest $10,000 in stock on the stock market, and after a year, it increases to $12,000. By calculating the difference between the final and beginning values, dividing by the initial value, and multiplying by 100, it is possible to get the average return:

Thus, Average return equals [(Ending value - Initial value)/ Initial value)] * 100.

The averagereturn is calculated as [($12,000 - $10,000) / ($10,000)] * 100 = 20%

Example 2

Consider a $5,000 worth investment in a mutual fund that would increase to $6,500 over the course of three years. The same formula as previously mentioned may be used to get the average return.

Thus, the average return is equal to [($6,500 - $5,000) / $5,000] * 100 = 30%

Example 3

Assume you spend $200,000 to purchase a rental property and sell it for $250,000 five years later. The average return may be determined in a similar manner:

Average return equals [($250,000 - $200,000) / $200,000] * 100, which equals 25%.

Example 4

Consider a $50,000 investment in a bond paying a 5% yearly interest rate. You will earn $55,000, plus interest when the bond matures after two years.

Thus, the Average return = [($55,000 - $50,000) / $50,000] * 100 = 10%.

Example 5

You can figure out the average return of your complete portfolio even if it is made up of a variety of investments, including stocks, bonds, and real estate. Imagine your portfolio has a $100,000 starting value that increases to $120,000 over the course of three years. In this case, the typical return would be:

Average return = [(120,000 - 100,000) / 100,000] * 100 = 20%

One should bear in mind that these are simplified examples, and do not take into account risk, taxes, fees, inflation, or other issues.

The Bottom Line

In different financial contexts, the average return is a commonly used statistic to assess the efficiency and profitability of investments. Average return offers important insights into the typical rate of return over a certain time period, which may be used to analyze stock market returns, mutual fund success in the past, real estate investment benefits, or business profitability. To make wise investing selections, it is essential to take into account additional elements, including risk, volatility, and market circumstances, in addition to the average return. Investors may better grasp the returns produced by their investments and make wise financial decisions by comprehending and analyzing average returns along with other factors.