Average Return

What Is an Average Return?

The average return is a fundamental metric used to evaluate the performance of investments over a specific period. It provides investors and analysts with insights into the average rate at which an investment has grown or declined in value over time.

Average returns can be calculated for various time periods, such as daily, weekly, monthly, quarterly, or annually, depending on the frequency of returns data available and the desired analysis period. For instance, if you are evaluating the average return of a crypto asset over the past year, you could sum up the monthly returns for each month and divide by 12 (since there are 12 months in a year).

Calculating the Average Return?

There are various methods to measure returns, with the average return being the simplest. 

The formula is:

$\text{Average Return} = \frac{\text{Sum of Returns}}{\text{Time Period}}$

Example:

If an investment yields the following monthly returns over 6 months: 10%, 20%, 10%, 10%, 20%, and 20%, the calculation would be as follows:

Sum of Returns = 10% + 20% + 10% + 10% + 20% + 20% = 90%

Time Period = 6 months

Average Return = 90% / 6 = 15%

The average return over these 6 months is 15% monthly.

Use of Average Return?

Investors and analysts often use the average return to evaluate an asset's historical performance. By understanding past performance, they can make more informed decisions about future investments. This measure helps in evaluating the overall growth rate of an investment, thereby providing insights into its financial health.

Limitations of the Average Return

While average return provides a useful insight of performance, it has limitations:

• Compounding Ignored: Average return does not consider compounding effects, which can significantly impact actual investment returns over time, leading to an overestimation or underestimation of an investment’s actual performance.
• Volatility and Timing: It assumes returns are evenly distributed over the period, whereas in reality, returns can vary widely from one period to another.
• Risk Adjustment: It does not provide a measure of risk-adjusted performance, which is essential for evaluating how much risk was taken to achieve the returns.