Average return calculates the expected rate of return on an investment portfolio, taking into account the risks involved. It can be used in capital budgeting and stock analysis to determine the probable value of a project or portfolio. Geometric mean return calculates the proportional change in wealth over time, taking into account the compounding effect.
An investment portfolio faces risks that could affect the actual return obtained by the investor. There is no method of accurately calculating actual return, but average return takes into account the risks a portfolio faces and calculates the rate of return an investor can expect to earn on that particular portfolio. Investors can use the concept to calculate the expected return on securities, and company managers can use it in capital budgeting when deciding whether to take on a certain project.
In capital budgeting, this type of calculation considers several possible scenarios and the probability that each scenario will occur; then use these figures to determine the probable value of a project. For example, a project has a 25 percent chance of generating $1,200,000 US dollars (USD) under good circumstances, a 50 percent chance of generating $1,000,000 USD under normal circumstances, and a 25 percent chance of generating $800,000. USD in bad circumstances. The average return on the project is then = (25% X $1,200,000 USD) + (50% X $1,000,000 USD) + (25% X $800,000 USD) = $1,000,000 USD.
In stock analysis, the average return can be applied to a security or a portfolio of securities. Each security in a portfolio has an average return calculated using a formula similar to that for capital budgeting, and the portfolio also has a return that predicts the average expected value of all the likely returns of its securities. For example, an investor has a portfolio consisting of 30 percent A-shares, 50 percent B-shares, and 20 percent C-shares. The average return on A-shares, B-shares, and C shares is 10 percent, 20 percent, and 30 percent, respectively. The average return on the portfolio can then be calculated as = (30% X 10%) + (50% X 20%) + (20% X 30%) = 19 percent.
This type of calculation can also show the average return over a certain period of time. To perform this calculation, there must be data for a few time periods, with a larger number of periods producing more accurate results. For example, if a company earns a return of 12 percent in year 1, -8 percent in year 2, and 15 percent in year 3, then it has an arithmetic mean annual return of = (12% – 8% + 15%) / 3 = 6.33%.
Geometric mean return also calculates the proportional change in wealth over a particular period of time. The difference is that this calculation shows the growth rate of wealth if it grows at a constant rate. Using the same figures as in the previous example, the geometric mean annual return is calculated as = ((1 + 12%) (1 – 8%) (1 + 15%)) 1/3 – 1 = 5.82%. This figure is less than the arithmetic average return, because it takes into account the compounding effect when interest is applied on an investment that has already earned interest during the previous period.
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