Meaning of Average Return
The average return refers to the simple mathematical average of a series of returns generated over some time. With any set of numbers, an average return is calculated the same way a simple average is calculated. The numbers are summed up into a single sum. It is then divided by the number in the set.
A simple arithmetic mean is one example of average return. For example, assume that investment returns the following annually over five years: 12%, 8%, 10%, 5%, and 20%. The five annual returns are added together and then divided by 5 to calculate the average return for the investment over these five years. It yields an average yearly return of 11%.
Calculation of Average Return Explained
There are several return measures and ways to calculate them, but one takes the sum of the returns for the arithmetic average return and divides it by the number of returns, as follows:
Average Return = Sum of Returns/Number of Returns
The simple rate of growth is a function of the values or balances which begin and end. It is determined by subtracting the end value from the start value and then dividing it by the start value. The definition is read as follows:
Growth Rate = (BV-EV)/BV
BV represents Beginning Value, while EV represents the Ending Value.
Looking at the average historical returns, a more accurate calculation is the geometrical average. The geometrical mean is always inferior to the average return. One advantage of using the geometric mean is that there's no need to learn the exact sums invested.
The calculation focuses entirely on the return figures themselves and presents a comparison of "apples to apples," when looking at the performance of two or more investments over more different periods.
The geometric average return is often referred to as the time-weighted rate of return (TWRR) since it excludes the effects of any distorted growth levels generated over time by different inflows and money outflows into an account.
Alternatively, the money-weighted return rate (MWRR) includes the size and timing of cash flows, making it an effective measure for portfolio returns that have received deposits, dividend reinvestments, interest payments, or withdrawals. The money-weighted return equals the internal rate of return, where the net present value is zero.
Uses and Limitations of Average Return
The average return tells an investor or analyst about the past returns for a stock or security. Also, it informs about the returns from a portfolio of companies. It is not identical to an annualised return. The average return is without compounding.
The simple average of returns is an easy calculation, but it is not very accurate. For more accurate returns calculations, analysts and investors also frequently use the geometric mean or money-weighted return.
