What Is the Average Rate of Return?
When you see the word ‘average’ return, it’s worth checking how the average was calculated. Here is an example of two managed funds: Fund A managed by Mr. X, and Fund B managed by Mr. Y. Mr. X tells potential investors that he has earned Fund A investors an ‘average return of 20% per year’, compared with Mr. Y whose Fund B earned an average of only 10% per year. Usually you find the average of a set of different values by adding up all the values, and dividing that total by the number of values. This is called the arithmetic mean. Mr. X’s Fund A earned 100% in the first year, but then lost 60% in the second year. Using this arithmetic method, we can see that Mr. X can truthfully claim the average of +100% and –60% is 20%. Mr. Y’s Fund B earned just 10% in the first year, and earned 10% again the next year. Of course, Mr. Y’s arithmetic average is 10%. An investor who put $100 into the ‘20% average’ Fund A will see their opening balance of $100 grow to $200 at the end of the first year,
