Average Annual Return (AAR)

Definition

The Average Annual Return (AAR) is a percentage used in finance that represents the average returns an investment yields over a certain period of time on an annualized basis. It is calculated by taking the geometric average of a series of annual returns. It is often used to compare the annual performance of different investments.

Phonetic

The phonetic pronunciation for Average Annual Return (AAR) is: “Av-er-age An-nu-al Re-turn” (AA-R)Please note, in English, the term is pronounced exactly as it is written so a phonetic representation may not be needed.

Key Takeaways

1. The Average Annual Return (AAR) measures the money made or lost by an investment each year over a given period. It presents a historical performance of investments like stocks, mutual funds, or bonds.
2. AAR is a mean and it calculates the return on an investment which might result in a smooth trend. However, it may potentially oversimplify the performance of an investment as it doesn’t account for investment risk or market volatility.
3. While AAR can give a broad overview of an investment’s historical performance, it should be used along with other metrics and financial information to make Investment decisions as it could be misleading when regarded in isolation.

Importance

The Average Annual Return (AAR) is a crucial metric in business and finance because it provides an overview of an investment’s performance over a specific period. It averages out the yearly gains or losses, which helps investors or financial analysts to evaluate the effectiveness and profitability of an investment over time. Regardless of short-term volatility or fluctuations, AAR provides a more comprehensive and consistent understanding of an investment’s long-term trend. By using AAR, investors can compare different investment opportunities and make more informed decisions about their investment strategies and portfolio management.

Explanation

Average Annual Return (AAR) is a key tool used by investors to measure the historical performance of an investment or a portfolio. Whether one is dealing with stocks, bonds, mutual funds or ETFs, the AAR provides a snapshot of how an investment has fared over a certain period of time, usually yearly. By giving an annualized snapshot, it allows investors to more easily compare different types of investments or the same investment across different time frames. The AAR is particularly useful when measuring the long-term performance of an investment. It takes into account the compounding of returns, which is especially important with investments that produce dividends or interest. It also provides a way to smooth out the performance fluctuations that can occur from one year to another, enabling a more consistent picture of performance. With the AAR, investors can make better-informed decisions about where to allocate their money, based on their tolerance for risk and their investment goals.

Examples

1. Mutual Funds: An example of Average Annual Return (AAR) can come from investing in mutual funds. When an investor is considering investing in a mutual fund, they commonly look at the AAR of the fund. For instance, if a mutual fund has a 10% AAR, that means it has averaged a 10% return on investment each year over a given period. 2. Stock Market: The S&P 500, which is an index that benchmarks the performance of 500 of the most significant companies listed on the U.S. stock market, has an AAR around 10% since its inception in 1926. This is often used as the “average return” by financial advisors when giving advice about potential returns from investing in the broad stock market. 3. Individual Stocks: Let’s consider the example of an individual stock of a company. Let’s say Company X had returns of 15% in Year 1, -5% in Year 2, and 20% in Year 3. The AAR of Company X’s stock would be 10% ([15 – 5 + 20] / 3), which shows that on average, the annual return for the stock over these three years was 10%.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Compound Annual Growth Rate (CAGR)
• Rate of Return (RoR)
• Annualized Return
• Standard Deviation (measure of volatility)
• Investment Portfolio Performance

Sources for More Information

• Investopedia
• The Business Professor
• Fincash
• Finance Unlocked