The Misleading of Return Calculation

There are some definitions of return in financial market.  Return is the main purpose of all investments. In general, investors want positive and the highest return. However, the return can be negative and the results will decrease the total wealth of investors.

A positive but smaller return on investment than periodic inflation will result in total investor wealth growing nominally but decreasing in real terms. The illustration is that an investor who only gets a return of five percent in one year when the annual inflation rate reaches seven percent will experience a real 2 percent (5-7 percent) decrease in real wealth even though the nominal amount of money increases by five percent, say from Rp100 million to Rp105 million. The point is the purchasing power of Rp105 million is two percent lower than the purchasing power of Rp100 million a year earlier. In general, the real return is the nominal return minus the inflation rate. For purchasing power is not reduced, the nominal return of an investment must exceed the rate of inflation.

Another things about return is how to calculate return. There are two types: arithmetic averages and geometric mean. Let say we have 6-year sequence of investment returns as follows: 30%, -20%, 30%, -20%, 30%, and -20%.  For the arithmetic average, we just sum of all returns and divided by 6 and the result is five percent. While, in geometric mean, first we need to add 1 to each return to avoid problems with negative number and multiple each return. Then, raise the answer to the power of one divided by the count of the numbers in the sequence. Finally, subtract one from the result. Based on this calculation, we get 1.98% as the return for geometric mean. This is the real return of investors, instead of the fund manager will show you the arithmetic return. Geometric returns are certainly lower than arithmetic returns so return geometrics are often referred to as more conservative measurement.

In short, watch carefully when invest your money and make sure the definition of return of your investment.

18 thoughts on “The Misleading of Return Calculation

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