In short: The Average Yearly Return is the midpoint of several returns on investment added up and divided by the number of years; the average.
The average annual return is used by investors to measure the performance of investments over a period of time. It is a percentage which is used while reporting the previous returns over a certain period, like 3-, 5-, and 10-year average returns of a stock. The average annual return is calculated net of a fund’s operating expense ratio. So it does not include sales charges, transactioncosts or brokerage commissions.
While selecting a stock, the average annual return acts as a guide in measuring the long-term performance of a stock. Besides, it is also essential for an investor to look at the yearly performance of a fund to fully understand the consistence of its annual total returns. A 5-year average annual return of 10%, for example, appears to be quite attractive. However, the average annual return can be inflated artificially because of a single “lucky” year.
Application of Average Annual Return
The estimation of average annual return takes into account the effects of compounding interest as it is more accurate than using the simple interest formula. Additionally, the average annual return provides the return in form of percentages instead of raw numbers.
Calculating the Average Annual Return
For calculating the average annual return, it is essential to know how much has been paid, how long the investment was held, and how much amount was received on the sale of investment. The steps involved in calculation of average annual return are:
1. At the first step, the ratio between the initial and the ending value of investment is calculated by dividing the ending value by initial value.
2. Divide 1 by the number of years for which the investment was held.
3. The ratio obtained as a result of step 2 is multiplied by the yearly percentage.
4. Subtract 1 from the result thus evaluating the Average Annual Return expressed in the form of a decimal.
Finally, the average annual return, expressed in decimals, is multiplied by 100 to obtain the average annual return expressed as a percentage.