Average Return

Definition

The average return is a measure of the central tendency of a set of returns, typically used in the context of investments and financial markets. It represents the typical or expected return an investor can anticipate from an asset or portfolio over a given period of time.

5 Must Know Facts For Your Next Test

1. The average return is a useful metric for comparing the performance of different investments or portfolios, as it provides a single, representative value that summarizes the overall return over a given period.
2. The average return can be calculated using either the arithmetic mean or the geometric mean, depending on the specific application and the desired interpretation of the results.
3. The geometric mean is often preferred for measuring the average rate of return on an investment over time, as it takes into account the compounding effect of returns and provides a more accurate representation of the long-term growth of an investment.
4. The average return is an important input for various financial models and calculations, such as the calculation of the cost of capital, the evaluation of investment strategies, and the assessment of portfolio performance.
5. The reliability and interpretation of the average return can be influenced by factors such as the volatility of the returns, the presence of outliers, and the length of the time period being considered.

Review Questions

• Explain the difference between the arithmetic mean and the geometric mean in the context of measuring average returns.
  • The arithmetic mean is the simple average of a set of returns, calculated by summing the returns and dividing by the number of values. In contrast, the geometric mean is the nth root of the product of a set of returns, where n is the number of values. The key difference is that the geometric mean takes into account the compounding effect of returns over time, providing a more accurate representation of the average rate of return. While the arithmetic mean is suitable for short-term or non-compounding returns, the geometric mean is preferred for measuring the average return on an investment over a longer time horizon, as it better reflects the actual growth of the investment.
• Discuss the importance of the average return in the context of investment performance evaluation and decision-making.
  • The average return is a crucial metric for evaluating the performance of investments and investment portfolios. It allows investors to compare the historical performance of different assets or funds, and to assess whether an investment has met its expected return objectives. The average return is used in various financial models, such as the calculation of the cost of capital and the evaluation of investment strategies. Additionally, the average return is an important input for making informed investment decisions, as it helps investors understand the typical or expected return they can anticipate from an asset or portfolio over a given period of time. By considering the average return, along with other relevant factors, investors can make more informed decisions about asset allocation, portfolio construction, and risk management.
• Explain how the reliability and interpretation of the average return can be influenced by factors such as return volatility, outliers, and the length of the time period considered.
  • The reliability and interpretation of the average return can be significantly affected by various factors. Highly volatile returns, with large fluctuations in the values, can make the average return a less representative measure of the typical or expected return. The presence of outliers, or extreme values in the dataset, can also skew the average return and make it less reflective of the overall performance. Additionally, the length of the time period considered can impact the average return, as longer time horizons tend to smooth out the effects of short-term fluctuations and provide a more accurate representation of the long-term growth of an investment. Investors must be aware of these factors and consider them when interpreting the average return, as they can have important implications for investment decision-making and performance evaluation.

Related terms

Geometric Mean:

The geometric mean is a type of average that is calculated by multiplying a set of numbers and then taking the nth root, where n is the number of values in the set. It is often used to measure the average rate of return on an investment over time.

Arithmetic Mean:

The arithmetic mean is the most common type of average, calculated by summing up all the values in a dataset and dividing by the total number of values. It is often used to measure the average return on an investment over a given period.

Time-Weighted Return: The time-weighted return is a measure of the growth of an investment over time, adjusting for the impact of cash flows in and out of the investment. It is commonly used to evaluate the performance of investment managers and mutual funds.