What is an average rate of return?
A mathematical mean of returns gained over a particular period of time is known as the average rate of return. It is determined using the same formula that is applied to calculate the arithmetic mean for any set of numbers.
How is an average rate of return calculated?
Now that we know what an average rate of return is, let us understand how it is computed with an example.
The returns are added together to derive a total value, which is then divided by the number of returns in the set.
Following is the average rate of return formula:
Average Return = Sum of Returns/Number of Returns
Assume the security or portfolio you have invested in has generated the following annual returns over a period of four years: 20%, 8%, 16%, and 8%.
Here is how we determine the average rate of return using the above-mentioned formula:
Average return = 20 + 8 + 16 + 8/4
=52/4
=13
So, your average return for a period of 4 years is 13%.
How to compute returns from value growth?
The average growth rate helps in evaluating if the value of an investment during a specified period has increased or decreased. Here is the formula for computing the growth rate.
Growth Rate = Beginning Value (BV) - Ending Value (EV)/ Beginning Value
For instance, assume you invest Rs. 1,00,000 in a company called XYZ, and its stock prices rise from Rs. 100 to Rs. 250 apiece. With the formula mentioned above, the growth value will be as follows:
= (Rs. 250 - Rs. 150)/ Rs. 250 = 60%
This 60% indicates an additional return of Rs. 60,000, appreciating your total stock value in XYZ to Rs. 1,60,000.
What does the average rate of return tell you?
The average return informs an analyst or investor about the past returns of an investment. Likewise, it can be useful in learning about the total returns you have made from a portfolio of organisations. Average returns are not to be confused with annualised returns, which are compounded.
What is the difference between average returns and annualised returns?
An annualised return is also computed using arithmetic mean. However, it incorporates compounding while determining the previous returns, whereas an average return excludes compounding. Typically, annualised returns are used to report gains made from equity investments. However, it is usually not the preferred analysis measurement technique because of its tendency to compound.
Additional read: Sub-broker
What are the limitations of an average rate of return?
The average rate of return formula is simply equivalent to the arithmetic mean computation. So it is very easy to use. However, this method is not precise enough. This is because it does not consider different capital outlays required for different projects. Similarly, it overlooks the possibility of future costs impacting profit. Instead, it only concentrates on the projected cash flows generated from a capital injection.
Also, average return fails to take into account the rate of reinvestment, presuming cash flows in the future can be reinvented akin to the internal rate of return (IRR). At times, the internal rate of return can deliver substantial yields. The circumstances contributing to such returns might be constrained or unavailable for the future, thereby making such implicit assumptions non-viable.
For more accurate data, analysts and investors make use of alternative calculation options like geometric mean or money-weighted rate of return (MWRR).
Additional read: Market capitalisation
What are the alternatives to the average rate of return?
There are two alternatives to the average return method: geometric average and money-weighted rate of return (MWRR).
Geometric average rate of return: The geometric average return is considered to be a much more ideal calculation while examining average historical returns. The geometric mean is always lesser than the results of the average mean. A positive aspect of the geometric mean method is that it does not depend on the actual investment amount details. To ensure a fair comparison while assessing the performances of two or more investments across different time periods, it completely relies on return figures. Often, this formula is referred to as the time-weighted rate of return or TWR because it disregards the inaccurate representation of multiple inflows and outflows of money on growth rates over a period.
Money-weighted rate of return (MWRR): Conversely, the money-weighted rate of return (MWRR) employs the size and timing of the cash flows for its computation. This makes it an effective measure for returns on a portfolio comprising dividend reinvestments, received deposits, and interest payments. The MWRR is equal to the internal rate of return (IRR) in scenarios where the net present value is equivalent to zero.
Closing thoughts
An average rate of return is a simple mathematical mean of a sequence of returns yielded over a specified period. This metric can help you measure the past performance of the concerned portfolio or stock. However, it might not prove to be one of the most ideal measures for charting a company’s growth value as it ignores multiple factors, such as future costs and rate of reinvestment. If you are looking for methods that could derive more accurate results about a company’s growth, then you can try using alternatives like geometric mean or money-weighted rate of return (MWRR) for your analysis.
