The average return is the mean value of a sequence of returns generated over a specified period of time.
What Is an Average Return?
It is the total return over a time period divided by the number of periods and is calculated the same way as a simple mean is calculated. Average Return is commonly used to calculate the average growth rate over a specific time period, which analyses the increase or decrease of an investment’s value.
Calculating the Average Return
There are many ways to measure returns – the simplest being the average return. The formula is as follows:
Average Return = Sum of Returns/Number of Returns
For example, an investment returns the following rate monthly over five months: 6%, 4%, 10%, 10% and 20%.
Sum of Returns = 6% + 4% + 10% + 10% + 20% = 50%
Number of Returns = 5
Average Return = 50% / 5 = 10%
The five monthly returns are added together and divided by five to calculate the average return over the five months. It returns an average monthly return of 10%.
How Is the Average Return Used?
Before making an investment, investors and market analysts use the average return to determine an asset’s past performance to judge the project’s financial health. It is also used to determine the returns of a company’s portfolio.
Limitations of the Average Return
The average return is a straightforward calculation, but not an accurate one. It ignores compounding; therefore, it is less popular among investors. When calculating the rate of returns, investors and market analysts prefer to use money-weighted returns instead. Another accurate measure used is the geometrical average, which is inferior to the average return because there’s no need to learn the exact sums involved. It is often referred to as the time-weighted rate of return (TWRR) as it ignores the effects of distorted growth levels produced over time for different reasons.