**What Is Average Return?**

The average return is a fundamental financial concept used to measure how well an investment or a group of investments has performed over time. It's the arithmetic mean of a set of returns over a specific period. Investors use this figure to get a sense of the average performance of an asset, without factoring in the effects of compounding. The formula for average return is quite simple: you sum up all the returns within a period and then divide by the number of periods.

For instance, if you earned 5%, 10%, and 15% from an investment over three years, the average return would be calculated as:

$\text{Average Return} = \frac{5\% + 10\% + 15\%}{3} = 10\%$This gives you a rough idea that, on average, the investment returned 10% per year.

**Key Takeaways**

**Basic Calculation**: The average return is simply the mathematical mean of all returns over a given period.**Historical View**: It offers insight into the past performance of an investment or portfolio, helping investors gauge potential future returns.**Ignores Compounding**: The average return doesn’t account for how gains or losses compound over time, unlike the more detailed**geometric return**.**Starting Point**: While useful for comparison, the average return may not provide a full picture, especially if investments differ in risk or volatility.

**Understanding Average Return**

The average return offers a basic glimpse into how an investment has performed, but it can sometimes give a misleading impression. For instance, it doesn’t consider the **volatility** or ups and downs in returns, nor does it factor in the **compounding** effects—how your gains (or losses) build upon each other over time. Therefore, while it can be useful, investors often need to pair it with other tools to get a clearer picture of an investment's potential.

**Example of Average Return Calculation**

Let’s look at an example to make things clearer. Suppose you invested in a stock that gave the following returns over five years: 10%, 15%, 10%, 0%, and 5%. To calculate the average return over these five years, you add up all the returns and divide by 5:

$\text{Average Return} = \frac{10\% + 15\% + 10\% + 0\% + 5\%}{5} = 8\%$This means that, on average, the investment returned 8% per year.

Now, let's use a real-life example. Assume shares of a company, like Walmart, produced the following returns over five years—9.1% in 2014, -28.6% in 2015, 12.8% in 2016, 42.9% in 2017, and -5.7% in 2018. The average return over this period would be:

$\text{Average Return} = \frac{9.1\% - 28.6\% + 12.8\% + 42.9\% - 5.7\%}{5} = 6.1\%$This shows that, on average, Walmart stock returned 6.1% per year over those five years, despite some major fluctuations.

**Why Average Return Can Be Misleading**

Although easy to calculate, the average return can sometimes give a false sense of security. This is because it doesn’t factor in how volatile an investment can be or how compounding works over time. For example, let’s say you made a 50% gain in one year but lost 50% in the next year. The average return might show as 0%, but you’d actually have less money than you started with due to the large fluctuation.

This is why many investors prefer to use the **geometric average** (also known as the **geometric mean**) because it accounts for the effects of volatility and compounding over time, providing a more accurate reflection of actual growth.

**Comparing Average and Geometric Return**

Let’s break this down further. The **geometric average** considers the compounding effect, meaning it looks at how your investment grows year after year. This is important because your gains (or losses) from one year carry into the next. The geometric average is often smaller than the arithmetic average in volatile markets, but it gives a more accurate picture of long-term growth.

For instance, if your investment earned 50% in one year and lost 30% in the next year, the arithmetic average would suggest a 10% return, which doesn’t tell the full story. The geometric average, however, would show that the actual return is much lower after compounding the effects of the loss.

**Money-Weighted Rate of Return (MWRR)**

Another way to assess investment performance is the **money-weighted rate of return (MWRR)**. Unlike the average return, which treats all periods equally, the MWRR considers the size and timing of your cash flows—such as when you add or withdraw money from the portfolio. This approach is more personal, as it reflects the actual return based on how much money you had invested at different times.

MWRR is especially useful for evaluating portfolios with frequent deposits or withdrawals. For example, if you added $10,000 to an investment in one year but took out $5,000 the next year, the MWRR would calculate how much return you made considering these changes. It’s closely related to the **internal rate of return (IRR)**, commonly used to evaluate investment performance over time.

**Why Investors Need More Than Just Average Return**

To truly understand how an investment has performed or may perform in the future, investors should go beyond the simple average return. Metrics like the **geometric mean** and **money-weighted return** offer deeper insights. The average return alone can’t tell you how volatility, the timing of your investments, or compounding will impact your overall returns.

For instance, if you invested $10,000 and the stock grew 20% in the first year but dropped 10% in the second year, the average return might show 5%, but your portfolio’s actual value would be different than if you earned a steady 5% annually.

**Conclusion**

The average return is a useful metric to gauge the historical performance of an investment, but it has its limitations. It doesn’t account for compounding, volatility, or the timing of cash flows, which can make a big difference in actual outcomes. To get a more accurate understanding of an investment’s true potential, investors should also consider additional metrics like the **geometric average** and **money-weighted rate of return**.

By combining these measures, you’ll be better equipped to make informed investment decisions and have a more complete picture of how your money is working for you over time.