What is Average Annual Return and How to Calculate It?

MoneyBestPal Team
A percentage that measures an investment's historical performance over a predetermined time frame, such as a mutual fund.
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Average annual return (AAR) is a percentage that measures an investment's historical performance over a predetermined time frame, such as a mutual fund. It is determined by multiplying the total number of years by the sum of the returns for each year. Investors frequently compare the performance of several investments or portfolios using the average yearly return.

However, because compounding is not taken into consideration when calculating the average annual return, it is possible that this figure may not accurately depict the growth of an investment over time. For instance, if an investment generates 10% of returns in the first year and 20% in the second, the average annual return is 15%, but the compound annual growth rate (CAGR) is 14.87%. Due to the fact that it takes into account both value changes over time and the reinvestment of earnings, the CAGR is a more accurate way to calculate an investment's annualized return.

Additionally, because the average yearly return does not account for an investment's risk or volatility, it does not accurately show how consistent or steady the returns are. The average yearly return, for instance, is 10%, but the standard deviation, which quantifies the range in returns from the mean, is 25.82% if an investment has four years of returns of -10%, 30%, -20%, and 40%. The standard deviation, which shows how much the returns differ from the average, is an often-used risk indicator. increased volatility and risk are indicators of increased standard deviation.

The average yearly return should therefore not be regarded as the only factor in making investment decisions, even though it can be a valuable tool for comparing the historical returns of various investments or portfolios. When assessing the performance and suitability of an investment, investors need also take other elements into account, such as compounding, volatility, risk, fees, taxes, inflation, and diversification.

How to Calculate Average Annual Return

To calculate the average annual return of an investment, follow these steps:
1. Identify the returns for each year of the investment period. For example, if you invested $10,000 in a mutual fund that returned 5%, 10%, -5%, and 15% in four consecutive years, your returns for each year are:

Year 1: $10,000 x 0.05 = $500

Year 2: $10,500 x 0.10 = $1,050

Year 3: $11,550 x -0.05 = -$577.50

Year 4: $10,972.50 x 0.15 = $1,645.88

2. Add up the returns for each year. For example:

$500 + $1,050 - $577.50 + $1,645.88 = $2,618.38

3. Divide the sum of the returns by the number of years. For example:

$2,618.38 / 4 = $654.60

4. Divide the result by the initial investment amount and multiply by 100 to get the percentage. For example:

($654.60 / $10,000) x 100 = 6.55%

The average annual return on the investment is 6.55%.

Average Annual Return Data for 2021

According to various sources, here are some examples of average annual returns for different types of investments or markets in 2021:
  • The S&P 500 index, which monitors the performance of 500 large-cap U.S. equities, returned an average of approximately 12.39% each year during the previous ten years and is expected to return around 28.71% in 2021.
  • The performance of U.S. investment-grade bonds is tracked by the Bloomberg Barclays U.S. Aggregate Bond Index, which had an average annual return of about 3.84% during the previous ten years and had a return of around -0.34% in 2021.
  • The performance of all stocks listed on the Indonesia Stock Exchange (IDX) is tracked by the Indonesia Stock Exchange Composite Index (IHSG), which had an average annual return of approximately 9% during the previous ten years and an annual return of about 18.73% in 2021.
As you can see, a variety of factors, including economic conditions, market trends, investor mood, industry success, company performance, etc., can affect the average yearly returns of particular assets or markets.

To decrease your exposure to any one source of risk and improve your chances of reaching your financial objectives, it is crucial to diversify your portfolio among many asset classes, sectors, industries, geographies, and methods.