Understanding Average Return: Definition, Formula, and Real-Life Examples

What Is Average Return?

The average return is the simple mathematical average of a series of returns generated over a specified period of time. It measures investment performance by helping to determine historical performance. The average return is calculated like a simple average for any group of numbers. Add the numbers to get a total, then divide by the quantity of numbers in the set.

The average return varies from annualized and geometric returns due to its lack of compounding consideration.

Detailed Insights into Average Return

There are several return measures and ways to calculate them. To find the arithmetic average return, add up the returns and divide by the number of returns.

$\text{Average Return} = \dfrac{\text{Sum of Returns}}{\text{Number of Returns}}$Average Return=Number of ReturnsSum of Returns​

The average return shows past returns for a stock, security, or portfolio of companies. The average return is not the same as an annualized return, as it ignores compounding.

Illustrative Examples of Average Return Calculation

One example of average return is the simple arithmetic mean. For instance, suppose an investment returns the following annually over a period of five full years: 10%, 15%, 10%, 0%, and 5%. To calculate the average return for the investment over this five-year period, the five annual returns are added together and then divided by 5. This produces an annual average return of 8%.

As a real-life example, Walmart's shares returned 9.1% in 2014, lost 28.6% in 2015, gained 12.8% in 2016, gained 42.9% in 2017, and lost 5.7% in 2018. The average return of Walmart over those five years is 6.1%, or 30.5% divided by 5 years.

How to Calculate Returns: A Focus on Growth

The simple growth rate is a function of the beginning and ending values or balances. It is calculated by subtracting the ending value from the beginning value and then dividing by the beginning value. The formula is as follows:

$\begin{aligned} &\text{Growth Rate} = \dfrac{\text{BV} -\text{EV}}{\text{BV}}\\ &\textbf{where:}\\ &\text{BV} = \text{Beginning Value}\\ &\text{EV} = \text{Ending Value}\\ \end{aligned}$​Growth Rate=BVBV−EV​where:BV=Beginning ValueEV=Ending Value​

For example, if you invest $10,000 in a company and the stock price increases from $50 to $100, then the return can be calculated by taking the difference between $100 and $50 and dividing by $50. The answer is 100%, which means you now have $20,000.

Exploring Alternatives to Average Return Calculation

Understanding the Geometric Average for Accurate Returns

When looking at average historical returns, the geometric average is a more precise calculation. The geometric mean is always lower than the average return. One benefit of using the geometric mean is that the actual amounts invested need not be known. The calculation focuses entirely on the return figures themselves and presents an apples-to-apples comparison when looking at two or more investments’ performances over more various time periods.

The geometric average return, also called the time-weighted rate of return (TWR), removes the distortions caused by money moving into or out of an account over time.

Evaluating Returns with the Money-Weighted Rate of Return (MWRR

The money-weighted rate of return (MWRR) considers the size and timing of cash flows, making it useful for portfolios with deposits, reinvested dividends, interest payments, or withdrawals.

The MWRR is equivalent to the internal rate of return (IRR), where the net present value equals zero.

The Bottom Line

The average return is the simple mathematical average of a series of returns over a specified period. It's useful in measuring the past performance of securities or portfolios, but it doesn't account for compounding, which may affect accuracy. Alternative measures like the geometric average and money-weighted rate of return provide more accurate calculations.

The average return provides only a general measure of past performance and should be used alongside other metrics for more comprehensive evaluations.