When you invest in a financial instrument, you earn a profit or incur a loss. This profit or loss is termed as the return on your investment. It accounts for any movement in the investment value, including dividends or interest payments and cash flows received by the investor from the investment.
You can calculate the return on an investment in absolute terms or as a percentage of the investment amount. Calculating the return over a standard period is advisable to compare investments based on returns.
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Average return calculates the average amount earned from an investment over some time. Its calculation is the same as a simple average. You sum up the returns for different periods into a single number and then divide it by the count of returns in the set.
You can calculate the average return before or after investing. Understanding the average return on a stock portfolio helps in analyzing the performance of your investments. It also helps in predicting future returns.
There are many measures and ways to calculate the average return. The easiest formula is for arithmetic average return.
Average return = Total value of the return/Total number of returns
With the measure of average return, you can assess the historical returns for a stock or security. You can also analyse the returns of a company portfolio. It is important to note that the average return is not the same as an annualised return, as the former does not consider compounding.
Given below are your mutual fund returns for the last six years. You can calculate your portfolio’s average return by adding the annual returns and dividing by 6.
Average return = (7 + 11 + 13 + 9.50 + 17 + 28) / 6 = 14.25%
The average return disregards compounding, but the annualized return is compounded when recording the previous returns. Generally, average annual return measures the returns of equity investments.
Since the annual average return compounds, it is mostly not considered an adequate analysis metric. Thus, it is irregularly used to evaluate changing returns. The calculation of annualized returns is completed through a regular mean.
Average return helps you make more informed financial decisions. It helps identify which investment avenue will reap higher returns and reflect greater growth potential. Once you know its function, you can make informed decisions for personal and professional investments.
Average return makes it easier for investors and analysts to compare various types of investments.
Average return allows you to consider any duration for calculations. Each investor has a specific time horizon, referring to how quickly they want to sell the investments.
Average return calculations are based on averages. They ignore outlying statistics in data sets. This is particularly helpful for long-term averages, where several years of profit can compensate for the losses of a single year.
While all investments are risky, average return considers the tangible impact of risks on returns. For the profits an investor can make from investments, the effect of one-time events on returns is irrelevant compared to gradual, consistent returns.
Despite its ease and effectiveness in measuring internal returns, the average return has many pitfalls. It does not regard different projects that can need different capital expenditures. It accounts for the returns in its entirety, with no distinction in terms of the performance of different projects.
Similarly, it does not consider potential costs that affect earnings. It focuses on projected cash flows resulting from capital investments. The average return also ignores the rate of reinvestment. Instead, it indicates that potential cash flows can be reinvented at rates similar to the internal rates of return.
Historical returns can give a fair idea of what you should expect to receive from your investments. But you must know that past performance cannot guarantee future results.
One of the most accurate measures of future outcomes is the average annual return for 15 years. The results in the short term may vary widely. The results of the past ten years might also not be able to give out the complete picture.
Average return offers an insight into the historical performance of stocks and securities. It gives you a fair idea of potential results, helping you decide whether or not you should commit money to a specific investment.