What Is Average Return?
Let me explain what average return means. It's the simple mathematical average of a series of returns generated over a specified period. You calculate it just like any simple average: add up the numbers into a single sum, then divide that sum by how many numbers there are in the set.
Key Takeaways
Here's what you need to know right away. The average return is that simple mathematical average of returns over time. It helps you measure the past performance of a security or portfolio. Remember, it's not the same as an annualized return because it ignores compounding. Also, the geometric average is always lower than the average return.
Understanding Average Return
You should know there are several ways to measure and calculate returns. For the arithmetic average return, you take the sum of the returns and divide it by the number of return figures. The formula is straightforward: Average Return equals the Sum of Returns divided by the Number of Returns.
This average return tells you what the returns for a stock or security have been in the past, or what the returns of a portfolio of companies are. But keep in mind, it's not the same as an annualized return since it doesn't factor in compounding.
Average Return Example
Let me give you an example of average return using a simple arithmetic mean. Suppose an investment returns 10%, 15%, 10%, 0%, and 5% annually over five full years. To find the average, add those up and divide by 5, which gives you an annual average return of 8%.
Now, consider a real-life case with Walmart shares. They returned 9.1% in 2014, lost 28.6% in 2015, gained 12.8% in 2016, gained 42.9% in 2017, and lost 5.7% in 2018. The average return over those five years is 6.1%, calculated as 30.5% divided by 5 years.
Calculating Returns From Growth
The simple growth rate comes from the beginning and ending values. You calculate it by subtracting the ending value from the beginning value and then dividing by the beginning value. The formula is Growth Rate equals (Beginning Value minus Ending Value) divided by Beginning Value, where BV is Beginning Value and EV is Ending Value.
For instance, if you invest $10,000 in a company and the stock price goes from $50 to $100, the return is the difference between $100 and $50 divided by $50, which is 100%. That means you now have $20,000.
Important Note
I want to point out something important: the simple average of returns is easy to calculate, but it's not very accurate. For better accuracy, you should look at the geometric mean or the money-weighted rate of return.
Average Return Alternatives
When you're examining average historical returns, the geometric average gives a more precise calculation. It's always lower than the average return. One advantage is that you don't need to know the actual amounts invested; it focuses purely on the return figures for a fair comparison across different investments and time periods.
The geometric average return is also known as the time-weighted rate of return (TWR) because it removes the distortions from money inflows and outflows over time.
On the other hand, the money-weighted rate of return (MWRR) factors in the size and timing of cash flows, making it suitable for portfolios with deposits, dividend reinvestments, interest payments, or withdrawals. The MWRR is the same as the internal rate of return (IRR), where the net present value is zero.
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