In finance, the return on an investment is essentially the profit that you gain from your investment. It covers any change in the value of the investment, such as interest payments or dividends, and/or cash flows that the investor receives from the investment. It can be calculated either in absolute terms or it can be calculated as a percentage of the amount invested (meaning, in currency). The latter is often called the holding period return as well.
A loss is defined as a negative return instead of a benefit, assuming the amount invested is greater than zero.
It is useful to convert each return to a return over a time period of a standard duration in order to compare returns over time periods of varying lengths on an equal basis. The consequence of the conversion is called the rate of return. In most cases, the standard time period is one year.
What is average return
The mathematical average of a series of returns produced over a period of time is the average return, also known as the average rate of return (ARR) . An average return is measured the same way as a simple average is calculated. The numbers are added together into a single sum, and the sum is then divided by the count of the numbers that have been added.
Mathematically, it can be represented as = The sum of all returns / The number of returns
What can average return tell you
The average return can tell you what the historical returns for a stock or security have been or what the returns of a company portfolio are. This is not equivalent to an annualised return. The average return disregards compounding.
Average return versus annualized returns
A lot of investors look at annualized returns. Annualized returns, also known as geometric returns, are not the same as average returns.
Volatility is taken into account by annualised returns. It’s the annual rate of return, no matter what happened in the middle, that brings you from your starting value to your ending value.
Average returns are essentially the arithmetic mean of all annual returns. Average returns will often be greater due to the smoothing inherent in the annualised return, even where the standard deviation is zero. The larger the standard deviation, the greater the disparity between average returns and annualised returns would be.
The pros of using average return
Flexibility in time period to be analyzed
Any time period that an investor determines can be covered when the average return is calculated. Each investor has its own horizon of time i.e., to how quickly the investor will want the investment to be sold.
Eliminates outliers
Since it depends on averages, outlying statistics in data sets are removed by the average return rate process. This is particularly useful for long-term averages, where the effect of a single year of losses can be minimised by several years of gains. All investments involve risk, and the expected rate of return implicitly addresses the risk by factoring only its tangible impact on the return of the investment into the average. In the amount of money an investment makes for its owners, one-time events that impact returns are not as relevant as gradual, steady patterns.
Simple way to compare
A simple comparison between various types of investments is made possible by the average rate of return process.
The cons of using average returns
In spite of being preferred owing to its characteristic of being a simple as well as efficient indicator of internal returns, there are many drawbacks to the average return. It does not account for numerous ventures that may require different outlays of capital.
In the same way, potential costs that impact earnings are ignored; instead it focuses only on the expected cash flows resulting from the influx of capital. The rate of reinvestment is also not taken into account by the average return; instead it implicitly implies that potential cash flows can be reinvented at rates close to those of the internal rate of return.This presumption is rather inefficient, considering the fact that the internal rate of return can often yield a relatively large amount, alongside the fact that in the future the factors for such return may be small or inaccessible. Apart from this, the calculation of the average returns does not factor in the time value of money either i.e., a hundred rupees today has more value than it will have in maybe 1 years. Investors as well as analysts tend to use cash-weighted return or geometric mean as the alternative metric for valuation because of these defects that are inherent to average returns.
Should you consider average returns of the investment instrument before investing?
While it is vital to keep in mind that past performance is not a guarantee of future outcomes, historical returns may provide fair expectations over time about an investment’s progress. The average annual return over the past 15 years is one of the most accurate gauges of future results. Short-term results vary widely, and even looking at the last 10 years does not always capture the complete picture.
Conclusion
Financial analysts as well as investors need tools to evaluate and compare investment instruments . Comparing very different types of investments, from stocks and bonds to real estate, commodities and foreign currencies, can entail this. Before deciding to commit money to a specific investment, the average rate of return approach is one way for investors to learn about their options. Rates of return can provide an insight into the historical performance of assets, and give an investor or analyst a fair sense of what can be expected. The average return is a simple ratio that provides this insight into the historical returns for a stock or security or what the returns of a company portfolio are.
