Average Return: Definition, Calculation, and Practical Applications
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Summary:
Delve into the intricacies of average return—a pivotal financial metric. Uncover the nuances of its calculation, its role in assessing past performance, and explore alternatives like the geometric average and money-weighted rate of return. This comprehensive guide equips investors and analysts with insights to make informed financial decisions.
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What is average return?
Within the realm of finance, the average return stands as a fundamental metric, offering valuable insights into the historical performance of investments. Let’s embark on a comprehensive exploration of this metric, its calculation, significance, and alternative measures.
The anatomy of average return
The average return is, at its core, a simple mathematical average derived from a series of returns over a specific period. The calculation mirrors the process of finding the average for any set of numbers—add all returns together and divide by the count of returns in the set.
This metric serves as a powerful tool for investors and analysts, providing a snapshot of past performance for individual stocks, securities, or entire portfolios. However, it’s crucial to note that the average return differs from the annualized return, as it does not take compounding into account.
The arithmetic average return
For the arithmetic average return, the calculation involves summing up individual returns and dividing by the number of returns. This method offers a straightforward way to gauge the historical performance of an investment.
Consider this example:
An investment returns 10%, 15%, 10%, 0%, and 5% annually over five years. The average return is calculated by adding these returns and dividing by 5, resulting in an annual average return of 8%. Real-world applications of this include assessing the performance of stocks like Walmart over specific timeframes.
Real-life example:
Shares of Walmart 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 of Walmart over those five years is 6.1%, calculated as the sum of annual returns divided by 5.
Calculating returns from growth
Understanding how returns relate to growth is essential in financial analysis. The simple growth rate, derived from beginning and ending values, is a key component. The formula involves subtracting the ending value from the beginning value and then dividing by the beginning value.
For instance, investing $10,000 in a company with the stock price increasing from $50 to $100 results in a 100% return, showcasing the importance of monitoring growth rates for informed investment decisions.
Alternative metrics: geometric average and MWRR
Beyond the arithmetic average, alternative metrics offer more precision in assessing returns. The geometric average, always lower than the average return, provides a nuanced comparison for investments’ performances over various time periods.
Geometric average: A precise calculation that focuses solely on return figures, offering an apples-to-apples comparison for investment performances.
Additionally, the money-weighted rate of return (MWRR) incorporates the size and timing of cash flows, making it effective for portfolios with deposits, dividend reinvestments, interest payments, or withdrawals. It aligns with the internal rate of return (IRR) concept, where the net present value equals zero.
Frequently asked questions
What is the difference between average return and annualized return?
The key distinction lies in compounding. While the average return provides a simple mathematical average of returns over a specified period, annualized return factors in the compounding effects, offering a more accurate representation of an investment’s performance over time.
How does the geometric average differ from the average return?
The geometric average is consistently lower than the average return. It provides a more precise calculation by focusing solely on return figures, eliminating potential distortions caused by various inflows and outflows of money into an account over time.
What is the significance of the money-weighted rate of return (MWRR)?
The MWRR incorporates the size and timing of cash flows, making it an effective measure for returns on a portfolio that has received deposits, dividend reinvestments, interest payments, or withdrawals. It aligns with the internal rate of return (IRR) concept, ensuring a comprehensive evaluation of a portfolio’s performance.
Why might the average return not accurately represent investment experience?
The average return, while providing a quick snapshot of historical performance, may not capture the true investment experience. It does not consider compounding effects and can be influenced by extreme values in the dataset, potentially skewing the overall representation of an investment’s performance.
Key takeaways
- Average return is a fundamental metric for assessing historical investment performance.
- The arithmetic average return provides a simple and quick calculation method.
- Alternative metrics like geometric average and MWRR offer more precise evaluations.
- Understanding the difference between average return and annualized return is crucial.
- Consider both pros and cons when utilizing average return for financial analysis.
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