Geometric Versus Arithmetic Means

Geometric Versus Arithmetic Means - In short, the...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
Geometric Versus Arithmetic Means 1 Arithmetic-Mean Returns These returns are simple averages of the returns experienced through time. Their virtue is that they are statistically correct estimates of expected returns. For instance, suppose you contemplate a two-year investment, and, in each of the two years, two outcomes are equally possible: up 50 percent or down 25 percent. You will, therefore, contemplate four possible scenarios of returns across two years: You Return Return Value Probability Weighted Invest Year 1 Year 2 Year 2 of Outcome Outcomes $1.00 50% 50% $2.2500 0.25 $0.562500 $1.00 50% -25% $1.1250 0.25 $0.281250 $1.00 -25% 50% $1.1250 0.25 $0.281250 $1.00 -25% -25% $0.5625 0.25 $0.140625 $1.265625 Expected Future Value The internal rate of return between $1.00 invested today and $1.265625 expected to be received in two years is 12.5 percent, which is equal to the simply arithmetic average of +50 percent and -25%.
Background image of page 1
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: In short, the arithmetic return describes expected returns well. Geometric-Mean Returns The geometric-mean return is the internal rate of return between one outlay and future returns. It measures actual investment experience better than the arithmetic mean. For instance, suppose you realize the following returns: Value of Investment--$1.00 1 100% $2.00 2-50% $1.00 Time Return The arithmetic-mean return is 25 percent. The geometric-mean return is 0 percent, which is exactly consistent with the fact that you have no more money at the end of the investment holding period than you invested at the beginning. In short, the geometric mean measures historical investment experience accurately. 1 I believe that the material above is based on a note published by Brunner (Darden) in conjunction with the Grand Metropolitan Case....
View Full Document

Ask a homework question - tutors are online