Average Return

Q: What is the difference between arithmetic and geometric average return?

Arithmetic average return is the simple mean of returns over multiple periods and is best for stable returns. Geometric average return, also known as compound annual growth rate, factors in compounding and is more accurate for volatile investments, reflecting true long-term growth.

Q: How do you calculate average return for multiple years?

To calculate average return for several years, add each year's return together and divide by the number of years. For example, if your returns were 10%, 5%, and -2%, the average return is (10% + 5% - 2%) ÷ 3 = 4.33%.

Q: Can average return be misleading?

Yes, average return can be misleading if there is high volatility in the returns. The arithmetic average does not account for compounding or variability, so geometric average or risk-adjusted metrics are preferred for more accurate assessment.

Q: How does average return relate to other metrics like ROI or IRR?

Average return summarises performance over time, but <a href="https://www.fundingagent.co.uk/finance-dictionary/return-on-investment">ROI</a> measures total return relative to investment, and <a href="https://www.fundingagent.co.uk/finance-dictionary/internal-rate-of-return">IRR</a> calculates the discount rate that sets net present value to zero. Each has different applications in financial analysis.

Q: Why is knowing average return important for business and investment decisions?

Average return helps compare options, set performance benchmarks, and plan for growth. It informs expectations for savings, investments, or project outcomes, and is central to portfolio management and business strategy.

Finance Dictionary >Average Return

Average return is a fundamental financial concept used to summarise the performance of an investment or portfolio over multiple periods. It represents the typical gain or loss an investor might expect based on historical outcomes. Investors, business owners, and finance professionals rely on average return to gauge past performance, develop expectations, and compare various investment options. Average return is central not only in personal investing but also in business finance and corporate analysis. Did you know that the average return provides a simple, yet sometimes misleading, snapshot that may overlook volatility?

What is Average Return?

Average return refers to the mean rate of return earned over a specified period for a single investment or a portfolio. Unlike single period measures such as rate of return, it aggregates results across multiple intervals, making it especially useful for investments where results fluctuate. For example, consider an investor who puts money into a mutual fund for three years. In the first year, the return is 6%; in the second year, it is 8%; and in the third year, it is 4%. To understand how the investment performed on average, the investor would calculate the average return. This measure helps answer questions such as, "What was the typical annual outcome?" or "How did this asset perform compared to return on investment (ROI) benchmarks?"

Calculating Average Return: Formula and Step-by-Step Example

The most commonly used way to compute average return is the arithmetic mean. Here is the basic formula:

Average Return = (R₁ + R₂ + ... + Rₙ) / n

Where R₁, R₂, ..., Rₙ are the periodic returns and n is the number of periods.

Practical Calculation Example: Suppose a business invests £10,000 in a project with annual returns of £700 (Year 1), £900 (Year 2), and £500 (Year 3).

Step 1: Calculate annual returns as percentages:
Year 1: £700/£10,000 = 7%
Year 2: £900/£10,000 = 9%
Year 3: £500/£10,000 = 5%

Step 2: Add all returns: 7% + 9% + 5% = 21%

Step 3: Divide by number of years: 21% ÷ 3 = 7%

Thus, the average return per year is 7%. While easy to apply, note that the arithmetic average can overstate expected results when returns are highly variable, because it does not account for compounding or volatility. For that reason, sometimes other averages like the geometric mean or measures like absolute return are also referenced in professional analysis.

How Does Average Return Work in Real-Life Investments?

Average return is used extensively in evaluating savings accounts, business investments, or portfolios. For example, if you are comparing two stocks over the past five years, and one shows an average return of 5% while another delivers 8%, you might initially consider the latter as better. However, if the 8% stock has extreme ups and downs, further investigation—using total shareholder return (TSR) or considering risk—may be warranted. Similarly, for a small business evaluating new projects, analysing the average return across several opportunities helps prioritise which ideas to pursue for consistent growth.

Types of Average Return: Arithmetic vs Geometric

There are two main calculations used in finance:

1. Arithmetic Average Return: This straightforward method adds all periodic returns and divides by the number of periods. Suitable for estimating typical outcomes when returns are stable.

2. Geometric Average Return (or Compound Annual Growth Rate): Reflects the effect of compounding, providing a more accurate picture for periods with fluctuating gains or losses. It is especially important for assets like stocks or funds where reinvestment occurs. The formula is:

Geometric Average Return = [(1+R₁) × (1+R₂) × ... × (1+Rₙ)]^(1/n) - 1

For the earlier example, those annual returns (7%, 9%, 5%) would give:

Geometric Return: [(1.07 × 1.09 × 1.05)^(1/3)] - 1 ≈ 6.99% per year

This shows how the result is slightly less than the arithmetic average, due to compounding effects.

When to Use Average Return and Related Considerations

The average return is widely used in portfolio analysis, budgeting, and capital allocation. It helps compare options, summarise profit trends, and guide resource decisions. However, understanding potential pitfalls is crucial. Arithmetic averages can mislead when returns differ significantly year to year. In such cases, geometric average is preferable. Other metrics, like accounting rate of return (ARR) or internal rate of return (IRR), provide deeper insight when analysing projects or investments over longer horizons.

Historical Use and Applications

Historically, analysts and investors used average return to track stock market results, property investments, and even compound interest from savings. Its simplicity made it popular in early finance textbooks and accounting practices. Today, advanced statistical tools are often used alongside average return to account for market complexity, risk preferences, and business cycles.

Final Thoughts: Making the Most of Average Return

While average return is vital for quick assessment, it should be applied considering the underlying data and volatility. When used wisely, it forms the foundation of good investment and budgeting decisions. If you want help applying these concepts to business growth or need support navigating funding for new projects, use this educational resource on the business funding solutions platform, where you can learn more about investing in your future.