Average Return: Meaning, Calculations and Examples

The average return of an investment over a specified period is a key metric for evaluating its performance, providing a snapshot of the returns generated over that time. Here's a detailed look at how to calculate it and what it reveals: 1. **Definition and Importance**: - The average return is the simple mathematical average of a series of returns over a given period. - It helps investors assess the historical performance of a stock, security, or portfolio, providing a baseline for evaluating profitability. 2. **Calculation Method**: - The formula for calculating the average return is: Average Return = Sum of Returns / Number of Returns. - For example, if an investment returned 10%, 15%, and 10% over three years, the average return would be (10% + 15% + 10%) / 3 = 11.67%. 3. **Comparison with Geometric Average**: - The geometric average is a more precise measure for investments with compounding returns, as it takes into account the effect of reinvestment of returns. - The geometric average is lower than the arithmetic average, making it a more conservative measure of returns. 4. **Real-World Example**: - Walmart's stock returned 9.1% in 2014, -28.6% in 2015, 12.8% in 2016, 42.9% in 2017, and -5.7% in 2018. The average return over these five years was 6.1%, highlighting the importance of considering volatility in returns. 5. **Understanding Average Market Returns**: - Historically, the average stock market return is about 10% per year, though this is before accounting for inflation losses. - Investors should be aware that while the average might seem attractive, individual year returns can vary significantly, with some years showing much higher or lower returns than the average. 6. **Limitations of Average Returns**: - Average returns do not account for compounding, which can significantly affect the growth of investment returns over time. - They also do not reflect the impact of inflation on purchasing power, which is crucial for long-term investments. In conclusion, while the average return provides a useful summary of historical performance, it should be considered in the context of other metrics and economic factors to gain a comprehensive understanding of investment outcomes.