The average rate of return on an investment is calculated by determining the total return over a period and dividing it by the number of periods.
Understanding Average Rate of Return
The average rate of return measures the average annual growth rate of an investment over a specified period. It helps investors understand the historical performance of an investment and compare it to other investment options.
Formula for Calculating Average Rate of Return
The formula for calculating the average rate of return is:
*(Ending Value - Beginning Value) / Beginning Value) 100% / Number of Periods**
Example:
Let's say you invested $10,000 in a stock five years ago, and the stock is now worth $15,000. Here's how to calculate the average rate of return:
- Ending Value: $15,000
- Beginning Value: $10,000
- Number of Periods: 5 years
Calculation:
(($15,000 - $10,000) / $10,000) * 100% / 5 = 10%
Therefore, the average rate of return on your investment is 10% per year.
Practical Insights:
- Time-Weighted Return: This method is useful for comparing the performance of different investment managers, as it removes the impact of cash flows.
- Dollar-Weighted Return: This method considers the timing and amount of cash flows, making it more appropriate for evaluating the performance of an individual investment.
- Average Rate of Return vs. Compound Annual Growth Rate (CAGR): CAGR considers the compounding effect of returns, while the average rate of return is a simple average.
Conclusion:
Calculating the average rate of return on an investment provides valuable insights into its historical performance. By understanding this metric, investors can make informed decisions about their investment strategies.
