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Average rate of return is a financial term that refers to the average amount of money earned or lost on an investment over time, as compared to the amount actually invested. It is commonly also called return on investment (ROI), and is usually expressed as a percentage, representing the total profit or loss relative to the initial capital. Since it essentially shows what kind of profit may be expected, an average rate of return projection is a key component in any investment strategy.
There are two basic ways of calculating an average rate of return — one which is limited to short term estimates, and one that is more suited for longer term projections. The arithmetic mean provides an average short term rate of return, while what is known as the geometric mean is used for rates with a longer term. The latter includes a variable for a given number of years, and therefore can be used to project out into the future.
The farther out into the future an arithmetic average rate of return is calculated, the less accurate it becomes. This discrepancy occurs because, unlike geometric mean, arithmetic mean does not account equally for positive and negative earnings as years go by. For example, if the average rate of return on $50 US Dollars' (USD) worth of capital, over two years, is 25% in the first year and -25% in the second year, the arithmetically calculated result will be $37.5 USD, which is incorrect. Using the geometric formula yields the correct result of $50 USD, as the amount of the initial investment never changed.
Though the formulas for calculating average rate of return are somewhat complex, the results are fairly easy to interpret. The rate will represent the percentage of the capital either gained or lost. A percentage greater than zero indicates a profit, while a number less than zero indicates a loss.
Neither method of average rate of return is totally comprehensive, and both make certain assumptions regarding market and economic conditions. Nevertheless, with these assumptions in mind, they can offer guidance on anything from personal finance to major corporate and business transactions. Often, a mutual fund or similar investment program will offer a prospectus to potential investors that includes statistics, such as historic and projected future average rates of return. Consumers may use this as a comparative tool for estimated profitability in choosing between various funds. Since they offer results in relative percentages, the very same equations can be used to estimate profits and cash flow associated with the acquisition of entire companies.