Investors often seek to measure the performance of their investments, and one commonly used metric is the average return. The average return provides a simple way to understand how a particular security or a portfolio has performed across a given time frame. In this article, we will explore what average return is, how to calculate it, and compare it with other return measures.
What Is Average Return?
The average return is the simple mathematical mean of a series of returns generated over a specified period of time. It is calculated by adding all the returns together and dividing the total by the number of returns considered. The formula is as follows:
[ \text{Average Return} = \frac{\text{Sum of Returns}}{\text{Number of Returns}} ]
This metric can be particularly useful for investors or analysts to gauge the past performance of a particular investment, whether it be a stock, bond, or a mutual fund.
Key Takeaways
- Simple Calculation: The average return is a straightforward calculation of returns over time.
- Past Performance Measurement: It helps measure the historical performance of securities or portfolios.
- Not the Same as Annualized Return: Unlike annualized returns, the average return does not consider the effects of compounding.
- Comparison with Other Measures: The geometric average is generally lower than the average return, highlighting the nuances in measuring investment performance.
Calculating the Average Return
To calculate average return, one must gather the historical returns over a specified period. For example, if an investment shows the following annual returns over five years: 10%, 15%, 10%, 0%, and 5%, the average return can be determined as follows:
- Add the annual returns: (10 + 15 + 10 + 0 + 5 = 40)
- Divide by the number of years (returns): (40 / 5 = 8\%)
Thus, the average return for this five-year period is 8%.
Real-Life Example
Let’s consider Walmart's stock returns over five years: 9.1% in 2014, -28.6% in 2015, 12.8% in 2016, 42.9% in 2017, and -5.7% in 2018. To calculate the average return:
- Sum of Returns: (9.1 - 28.6 + 12.8 + 42.9 - 5.7 = 30.5)
- Average Return: (30.5 / 5 = 6.1\%)
This indicates a modest average return of 6.1% over the five-year period.
Growth Rate Calculation
In addition to the average return, investors occasionally calculate the growth rate of an investment, which focuses on the beginning and ending values. The formula for growth rate is:
[ \text{Growth Rate} = \frac{\text{BV} - \text{EV}}{\text{BV}} ]
Where: - BV = Beginning Value - EV = Ending Value
As an example, if an investor puts $10,000 into a stock priced at $50, which increases to $100, the growth rate would be:
[ \text{Growth Rate} = \frac{100 - 50}{50} = 100\% ]
This signifies that the investment doubled in value.
Alternative Measures of Return
While the average return provides insight, it may not fully encapsulate the performance of an investment, especially for those with varied cash flows. Two popular alternatives are the Geometric Average and the Money-Weighted Rate of Return (MWRR).
Geometric Average
The geometric average offers a more nuanced perspective on return, especially when the returns are volatile. It is generally lower than the arithmetic average and is particularly beneficial for:
- Comparing the performance of several investments over different time periods.
- Assessing the impact of compounding returns.
The geometric average is also known as the time-weighted rate of return (TWR), as it mitigates the effects of cash inflows and outflows over time.
Money-Weighted Rate of Return (MWRR)
The money-weighted rate of return (MWRR), equivalent to the internal rate of return (IRR), accounts for the timing and amount of cash flows. This measure is especially useful in portfolios with various deposits, withdrawals, or dividend reinvestments. MWRR reflects the true economic return an investor has realized based on the timing of their cash flows.
Conclusion
Understanding average return is fundamental for investors who aim to gauge historical performance. While it provides valuable insights, relying solely on average return can be misleading, especially in volatile markets. By considering geometric averages and money-weighted rates of return, investors can achieve a more holistic view of their investments' performance. Thus, when evaluating any investment, it’s valuable to use a combination of metrics to arrive at informed investment decisions.