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Measuring Returns from Historical Data 📊

When we look at the performance of a stock over the last 5 years, we usually see different returns for each year (e.g., Year 1: 10%, Year 2: -5%, Year 3: 20%). To understand the "average" performance, we use two mathematical tools: the Arithmetic Mean and the Geometric Mean. Choosing the right one is critical for accurate reporting.

1. Arithmetic Mean Return

The Arithmetic Mean is the simple average of a series of returns. It is calculated by summing all the returns and dividing by the number of periods.

Formula:

Arithmetic Mean = ΣRi / n

Where:

  • Ri = Return in period i.
  • n = Total number of periods.
Note

Use Case: The Arithmetic Mean is best for estimating the return of a single period in the future. It is a good "typical" return.

2. Geometric Mean Return

The Geometric Mean (also known as the Time-Weighted Rate of Return or Compound Annual Growth Rate - CAGR) accounts for the compounding effect. It measures the constant rate of return that would yield the same ending wealth as the actual varying series of returns.

Formula:

Geometric Mean = [ (1 + R1) * (1 + R2) * ... * (1 + Rn) ] ^ (1/n) - 1
Important

Why it's better: The Geometric Mean is the only correct way to measure the growth of wealth over multiple periods because it accounts for the fact that a -50% loss requires a 100% gain just to break even!

3. Comparison between Arithmetic and Geometric Mean

The difference between these two means depends on the Volatilty (variability) of the returns.

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4. Solved Problem: The "Mean" Difference

Imagine a stock has the following returns over 2 years:

  • Year 1: +100% (Money doubles)
  • Year 2: -50% (Money halos)

Let's calculate both means:

1. Arithmetic Mean:

AM = [100% + (-50%)] / 2 = 25%

Interpretation: "On average, you made 25% per year."

2. Geometric Mean:

GM = [ (1.0 + 1.00) * (1.0 - 0.50) ] ^ (1/2) - 1
GM = [ 2.0 * 0.5 ] ^ (1/2) - 1 = 0%

Interpretation: "Over 2 years, your total growth was 0%."

Caution

In this case, if you invested ₹100, you'd have ₹200 after Year 1, and ₹100 after Year 2. Your actual return is 0%. The Arithmetic Mean (25%) is misleading, while the Geometric Mean (0%) tells the truth.

Summary

  • Arithmetic Mean is a simple average; useful for future single-period guesses.
  • Geometric Mean accounts for compounding; essential for tracking wealth growth.
  • Volatility creates a gap between the two. The higher the risk, the larger the gap.
  • In Portfolio Management, use the Geometric Mean for historical performance reports.

Quiz Time! 🎯

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