An average return is a calculation that makes it possible to determine the actual return that has been experienced with an investment over an extended period of time. An average return is different from an annual return, where the focus is on any gains or losses that took place within a specific twelve-month period. Often, an average return looks at rate of return involved for several different years, and translates that collection of annual returns into one simple percentage that applies to all the annual periods under consideration.
One of the best ways to understand how an average return is calculated is to consider the example of an investment that has been held for five years. While earning some return during each of those years, the percentage of those annual returns has varied somewhat. In order to determine the average return for those five years, it is necessary to add those five annual returns together, then divide that figure by five, the number of years under consideration. Typically, this is done by considering the returns as percentages, rather than actual dollar amounts.
For example, if an asset over the course of five years had annual returns of 10%, 8%, 9%, 11%, and 7%,, those annual returns would be added, then divided by five, making it possible to determine that the average return on that asset for the five years under consideration is 9%. The owner of the asset can then determine if continuing to hold the asset is a good idea, assuming that market conditions will not fluctuate sufficiently over the next several years and cause the asset to perform below this average return.
One of the benefits of calculating an average return is that it provides information that can be used to determine if the asset is providing enough of a return to make it worthwhile to continue holding that asset. Since it is not unusual for various investments and other assets to perform better in some years than others, calculating the average also helps to provide a perspective on that return that cannot be gained by simply considering each year’s return individually. As a tool to help investors decide whether to hold or to sell an asset, taking the time to calculate this type of return can minimize the potential of letting go of an investment that may have recently experienced very little return, but in fact has been quite profitable over the long term.