What is an Average Annual Return?

Malcolm Tatum

An average annual return is the amount of profits accumulated over a period of several years, divided to determine the average amount earned for each year under consideration. The basic formula for calculating this return involves adding the actual return generated during each year involved, then dividing that figure by the number of twelve-month periods under consideration. A figure of this type is especially helpful with assessing the value gained from a given investment over several years, even when the performance of that investment fluctuates over time.

Man climbing a rope
Man climbing a rope

While the calculation of an average annual return is normally associated with using data from several successive twelve-month periods, it is also possible to use this same approach to project the potential return over the course of several upcoming years. This is accomplished by taking the historical data associated with recent time periods, and converting them to an annual figure. For example, an investor could look at the earned return on a given security over the past two quarters, add those returns, and then multiply the sum by two. This will supply a projected annual return that can be applied to the upcoming year, assuming there is good reason to think the security will at least hold its current value.

There are several reasons why an investor would want to take the time to determine the average annual return. One has to do with maximizing the total worth of the investment portfolio. By determining the annual return on each investment, it is possible to decide if a given security is earning enough profit to hold on to the current shares, sell off a portion of the shares, or acquire additional shares.

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Another benefit of calculating the average annual return has to do with deciding to purchase a given security. By evaluating the historical performance of a stock over the last several years, it is possible to determine the average yearly earnings and decide if it is worth acquiring shares of that particular stock. Assuming that the stock option is expected to continue an upward trend, the investor can use the same formula to project the anticipated annual return and decide if acquiring shares of the stock is a good idea.

Businesses can also calculate an average annual return as a means of projecting future dividends payable to investors. This can aid in structuring budgets for upcoming quarters, deciding when and how to launch expansion projects, and if it would be in the best interests of the company to issue additional shares at some point over the next couple of years. From this perspective, calculating an average annual return can help a business avoid making costly mistakes, and preserve the financial integrity of the company over the long-term.

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