Average Annual Return: A Metric For Long Term Investment Performance

Posted on Posted in Mutual Funds

Average annual return gives the investor a metric to measure the perofrmance of his own investments and to evaluate the quality of potential investments.

The wise investor should perform a regular, objective analysis on the performance of his assets. Doing such an analysis helps you to overcome the very common human tendency of self-deception; a problem to which investors are particularly prone. As an investor, it is crucial that you take a sober, non-emotional assesment of your investing returns and consider whether you are either underperforming or meeting your goals.

To do such an assessment, the investor needs to have the correct tools. You should be familiar with certain formulas and terms in order to understand more fully the state of your asset portfolio.

The first step, of course, is to remember that the only goal of investing is to maximize your wealth. So, if you are not acheiving significant growth in profits, then your investments are underperforming and your money is not working as effectively as it should.

The next step is to realize that non-cash investments are volatile over the short term, so it is not sufficient to measue the success of your investment based on just a single year’s performance (annual return). Rather, since stock, bond and mutual fund investments are meant to perform well when measured over long periods of time, we need a metric for measuring this peformance.

One of the most important measurements of investment success when it comes to stock, bond and mutual fund investments is the Average Annual Return (AAR). The Average Annual Return is used as a means for making a report on the historical return of a investment. The AAR is determined after tallying the expenses that have been incurred – this includes the administration fees, broker fees, fund management fees, the 12b-1 fees (when applicable), as well as other incidental fees that may be incurred. In mutual funds, these expenses are deemed to be a portion of the fund’s expense ratio. Investors should also know that the Average Annual Return takes into account both reinvested dividends and distributions of capital gains.

The Average Annual Return is the calculation of the simple mathematical mean of annual returns over a specified period of time. Computing for the Average Annual Return is quite simple. All one has to do is to add the annual rates and then divide it by the number of years where the rates were lifted. Thus, the formula is:

Average Annual Return = (sum of annual rates) / (No. of years)

To illustrate, if for the year 2000, the annual rate is 10 per cent, and then it becomes 5 per cent the following year, then the average annual return for those two years is 7.5 per cent. The computation for the Average Annual Return clearly shows that this is not a compounded rate of return. Rather you first have to calculate the annual return for each year individually (10, 5), then add each annual return together (10 + 5 = 15), then divide by the total number of years (15/2=7.5).

Before we conclude this essay, here’s an article on how to use our annual return calculator to calculate the average annual return. Go ahead and give it a shot. Practice makes perfect.

Ok. It should also be clearly noted that the computation of the Average Annual Return will only include such expenses like sales commissions, if these factors are explicitly factoried in as part of the computation (in other words, when calculating the annual return, you may have to manually subtract various fees from your total return). To make things as easy as possible, you should always try to look at the bottom line figures: 1) how much did I start out with and 2) how much did I end up with.

The Annual Average Return can be a good barometer for determining the change of an investment over a period of several years. But investors should be careful how they interpret the Average Annual Return metric. Here’s what to look out for.

First, keep in mind that the average annual return can be artificially inflated by a single “lucky” year. You never want to go with an investment that is normally bad, but occassionally gets lucky. Say a mutual fund, over a 5 year period, has returns like this: 70%, 6%, -10%, -8%, 3%. This fund has an average annual return of 12.2%. On first glance, that looks pretty good. But notice that the number gets ridiculously inflated by its first year 70% return. As we see from the next four years, the fund’s first year was a fluke.

In addition to average annual return, you need to keep an eye on consistency and also calculate the average annual return over several three, five and ten year periods.