Returns are often described in terms of a standard "statistical average return" which is the sum of all period returns divided by the number of periods. Using this method with investments can often be misleading since it fails to take the account balance into account. Earning 10% on $100 obviously yields a lot less than earning a 10% return on $1000. This calculator can demonstrate how negative and wild individual period returns can have a dramatic impact on final account balances (actual return in investment) that simple average return doesn't express. |
Mr. Prospect to prove to you that average return is not as important as actual return, let me ask you these questions... Let's say, I have a hypothetical two year investment available and it is guaranteed to average 20% return per year and it costs $100 to invest (and it's not illegal, or a ponzi scheme or anything like that.) Without telling you anything else about the investment, let me ask you... Number 1, would you like to invest? and Number 2, do you expect to end up with more money than you started with? [BTW: The answer is always Yes & Yes.]. Ok, in year one we're going to take this pretend $100 and place it in an investment that is guaranteed to grow 100%, so at the end of the first year, you have a balance of $200. Now in the second year, that $200 account balance is guaranteed to go down in value by 60%. You're guaranteed to lose $120 that second year, leaving you with a final account balance of $80. So what was the average return for this period? We sum the individual returns 100 + (- 60) = 40% and divide by the number of years (2) so 40%/2 = a 20% average return. Congratulations, you averaged 20%. What matters however, is how much money is left in the account.You started with $100 and ended up with $80, your actual return was -20% on your investment. So Mr. Prospect, do you really care about what the account averages - no, you really care what the actual return is. Average return is mathematics. Actual return is how money works. And those two things are not equal. |
Each period is calculated as follows: Annual Gain/Loss = Beginning of Year Balance * Annual Rate of Return. End of Year Balance = Beginning of Year Balance + Annual Gain/Loss. The average rate of return is calculated as follows: Average Rate of Return = Summation of [Individual Period Rates of Return] / number of periods. The actual return on investment is calculated as follows : Actual Return on Investment = ((Ending Balance / Starting Balance) - 1) * 100. The annualized rate of return is calculated using the following time value of money calculation: Actual Rate of Return = RATE(Number of Periods, 0, Starting Balance, Ending Balance). |