Average return is a financial term that refers to the mean value of a series of returns over a period of time. Investors use this metric to assess the performance of a particular asset or investment strategy. It is an important measure because it helps investors understand the potential return of an investment and the associated risk. In this article, we will explore what average return is, how it is calculated, and provide examples of its use.
Meaning of Average Return
Average return, also known as arithmetic mean return, is a measure of the expected return of an investment. It is calculated by adding up the returns of an investment over a period of time and dividing by the number of periods. This gives investors an idea of what the average return on their investment has been over the specified time frame.
Calculating Average Return
To calculate average return, you will need to know the total return of the investment over a given period of time and the number of periods that the investment was held. For example, let’s say an investor holds a stock for three years and the returns for each year are as follows:
Year 1: 10% Year 2: 20% Year 3: -5%
To calculate the average return, you would first add up the individual returns:
10% + 20% – 5% = 25%
Then, divide by the number of periods:
25% / 3 = 8.33%
Therefore, the average return for this investment over the three-year period is 8.33%.
Use of Average Return
Average return is an important metric for investors because it provides a way to evaluate the historical performance of an investment. By comparing the average return of different investments, investors can determine which investment has historically performed better. Additionally, the average return can be used to estimate the expected return of an investment in the future.
For example, if an investor is considering two different stocks, they can compare the average returns of each stock over a specific period of time to help decide which investment may be more profitable. If stock A has an average return of 10% over the past five years and stock B has an average return of 5% over the same period, the investor may lean towards investing in stock A since it has historically performed better.
Average return can also be used to estimate future returns. Although past performance does not guarantee future returns, investors can use the average return as a starting point for estimating what the expected return may be. For example, if an investor is considering a mutual fund that has an average return of 8% over the past 10 years, they may estimate that the expected return for the next year will be around 8%.
Limitations of Average Return
It is important to note that average return has limitations as a measure of investment performance. First, it does not account for the volatility of an investment. An investment may have a high average return, but if it experiences significant fluctuations in value, the actual return for the investor may be much different than the average return.
Second, the average return does not take into account the timing of returns. For example, an investment may have an average return of 10% over a five-year period, but the majority of that return may have come in the first year. This means that the actual return for the investor may be much lower if they did not invest during the first year.
Conclusion
Average return is a useful measure for evaluating the performance of an investment over a period of time. By calculating the average return, investors can compare the historical performance of different investments and estimate future returns. However, it is important to remember that average return has limitations and should not be the only metric used to evaluate investment performance. Investors should also consider other factors such as volatility and timing of returns.
