Average Returns in Investments

Understanding Average Return

The average return is the simple mathematical average of a series of returns generated over a specified period of time, offering a straightforward method to gauge the performance of an investment or a portfolio. It’s calculated by summing up the returns and dividing by the number of periods.

Key Takeaways

• The average return provides a primary look at historical performance by calculating the simple arithmetic mean of return series.
• It differs significantly from the annualized return, which accounts for the effects of compounding.
• Unlike the geometric mean, which considers the compound interest, the average return uses a simpler, though often less accurate, calculation formula.

Calculation Insights

For practical insights, assume you invest in a stock portfolio with annual returns over five years as follows: 10%, 15%, 10%, 0%, and 5%. Summing these (10+15+10+0+5) gives 40, which, divided by the number of years (5), equates to an average return of 8%. This calculation illustrates how straightforward the process is, yet it oversimplifies the impact of varying yearly gains and losses on the overall investment growth.

Practical Example: Real-Life Figures

Take, for example, a real-world scenario with Walmart shares over five specific years: gaining 9.1% (2014), losing 28.6% (2015), rising by 12.8% (2016), jumping 42.9% (2017), and a decline of 5.7% (2018). The average return sums these figures (divided by the number of years), resulting in an approximate annual average of 6.1%, which reflects general volatility without bias towards any particularly bad or good year.

Average Return Alternatives

Geometric Average

More precise than the arithmetic average, the geometric average is beneficial for a realistic assessment of investment performances over time, as it addresses the effects and fluctuations in annual returns. The calculation provides a comparative basis devoid of the inflow and outflow impacts on the portfolio.

Money-Weighted Rate of Return (MWRR)

The MWRR, another alternate measure, calculates the rate of return that sets the present values of all cash inflows and outflows equal to the cost of the initial investment. It’s particularly useful when the cash flow series is complex.

Beyond Average Returns

While simple average return is a useful indicator, it’s crucial for investors to consider more robust measures like the geometric mean or the money-weighted rate of return to get a true picture of an investment’s performance, accounting for factors such as reinvestment and the timing of cash flows.

Related Terms

• Annualized Return: Adjusts the average return to reflect a year-over-year calculation, accounting for compounding.
• Volatility: Measures the degree of variation of a series of investment returns.
• Risk Assessment: Evaluates the potential financial loss in investment scenarios.

Suggested Reading

1. “The Intelligent Investor” by Benjamin Graham - A staple for understanding investment philosophy, including detailed chapters on various forms of investment analysis.
2. “A Random Walk Down Wall Street” by Burton Malkiel - Offers insights into the investment strategies and the importance of understanding different types of returns.

Understanding average returns is just the tip of the financial literacy iceberg, and with the myriad of measurements available, your toolkit for investment analysis can only grow more robust. So, dive in, calculate away, and may your averages always trend upwards!