There are different ways of calculating the return on an investment, and a lot of people unknowingly work with a “not so good” method and expect less than they should as their returns. The differences in calculation methods can produce striking dissimilarities over time. Investors that are aware of this are normally careful, and will do the necessary researches to make sure their option will serve them best. Anyone can do that too.

If really there are dissimilarities in different methods of investment return calculations, which of them is the best option? There is need for a good understanding of economic reality in order to efficiently pick what option to work with. Economic reality here refers to interest rate, volatility, liquidity, inflation and deflation, etc. There are quite a bunch of alternatives for this calculation, but the one that stands out among the rest is the “geometric average”.

GEOMETRIC AVERAGE/MEAN OR COMPOUND AVERAGE

The aim here is to find an investment return, putting some things into consideration, and after a period of time must have elapsed. The geometric average is one good way of doing that. It is defined as the average of a set of products used to determine the performance result of an investment. A specific characteristic of this method of calculation is that it does not focus on the startup capital. It works with the return figures of a business deal and makes appropriate comparisons to reach the best output possible.

ILLUSTRATION; INVESTMENT RETURN CALCULATIONS

To illustrate how this works, here is an illustration. If the total return (the rate of profit made from an investment over a period of time) of an investment over a three year period is as follows

First year: 20%

Second year: minus 15%

Third year: 10%

What is the average investment return?

First, change the percentage values to decimal numbers and add 1 to each of them

First year: 20% = 0.2

0.2 + 1 = 1.2

Second year: -15% = -0.15

-0.15 + 1 = -0.85

Third year: 10% = 0.1

1. + 1 = 1.1

The nest thing is to multiply them together to get a product

1.2 X 0.85 X 1.1 = 1.122

Next, raise the product to the power of three representing the number of periods being considered in the calculation

1.122 ^ 3 = 1.4125

The answer has to be put in percentage form. That can be done by subtracting 1 from the answer and multiplying it by 100

1.4125 – 1 = 0.4125

0.4125 X 100 = 41.25%

This shows that the business earned 41.25% after a period of three years.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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