What is Average Return?

Definition

The average rate of return is the simple mathematical average of a series of returns generated over a specified period. The calculation method is the same as for any set of numbers: sum the numbers to get a total, then divide the total by the number of numbers in the set.

Origin

The concept of the average rate of return originates from basic principles in statistics and finance, used to measure the performance of an investment or asset over time. As financial markets evolved, the average rate of return became a crucial tool for investors to assess investment returns.

Categories and Features

The average rate of return can be divided into arithmetic average return and geometric average return. The arithmetic average return is suitable for calculating independent returns, while the geometric average return is more appropriate for long-term investments considering compounding effects. The arithmetic average is simple and easy to understand but may overlook volatility, whereas the geometric average better reflects actual investment growth.

Case Studies

Case 1: Suppose an investor has returns of 5%, 10%, and 15% over three years. The arithmetic average return is (5%+10%+15%)/3 = 10%. Case 2: A company has annual returns of 3%, -2%, 4%, 6%, and 5% over five years. The arithmetic average return is (3% - 2% + 4% + 6% + 5%)/5 = 3.2%.

Common Issues

Investors often misunderstand the applicable scenarios for arithmetic versus geometric average returns. The arithmetic average is not suitable for investments with high volatility as it may overestimate actual returns. The geometric average better reflects the true return of long-term investments.