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What is the Average Rate of Return?
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.
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Discussion Comments
There are several online sites where you can use an average rate of return calculator. These are nice because they quickly determine the possibilities of a projected rate of return.
While the calculations are pretty much the same, I look at it differently depending on whether the investment is for the short term or long term.
If I am buying a stock that I think will increase in value pretty quickly, I expect my average rate of return to be quite high over a short period of time.
On the other hand, if I am looking to buy a stock and hold on to it for the long term, I don't look for an average rate of return that is as high. I am happy with a slow move up as long as it continues to be profitable.
I don't know a whole lot about stocks or investing, but I do keep an eye on my 401(k). It is pretty easy to look at an annual statement and see how this has done over the course of a year.
Looking at the average rate of return is one thing I use to determine if I need to make any adjustments where my money is going. This is still a hard decision to make because it seems like just as soon as I switch it out of one investment into something else, that first investment starts to improve again.
I have a friend who is a financial adviser and he says that when given enough time, a stock market average rate of return is still much better than investing in a certificate of deposit or money market account.
@golf07 - Yes, there have been a lot of changes in an average annual rate of return over the past several years. I worked in the finance industry for many years, and I saw a lot of changes during that time.
When someone came to us interested in investing in one of our products, we always had to remind that that past historical returns were not a guarantee of future results.
In other words, it is good to know what that particular investment has done in the past, but that is never a guarantee it will continue with that rate of return. Most people already know that, but we were obligated to always make that clear to them.
It is still important information to consider. I know very few people who feel confident investing in something that has a negative rate of return several years in a row.
When I am looking at a potential mutual fund company to invest in, one of the first things I look at is what their mutual fund average rate of return has been.
I like to look at everything from the 10 year average down to the last 6 months. This gives me a good long term and short term snapshot of how the fund has been performing.
I know there are several factors that go into this calculation and it is more than just the numbers shown, but it is still a good indicator of the strength of the fund.
Sadly, the average rate of return on many of these funds is much lower than it was years ago. It used to be pretty easy to find a 10% rate of return, but now that is consistently much harder to find.
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