12.5.

More about average returns

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CẦN QUAN TÂM, CŨNG KHÔNG CÓ TRONG BÀI LUNN NHA CẢ NHÀ IU.

* Make the case (Đặt vấn đề): Let’s start with a simple example.
- Suppose you buy a particular stock for $200.
- Unfortunately, the first year you own it, it falls to $100.
- The second year you own it, it rises back to $200, leaving you where you started (no
dividends were paid).
 What was your average return on this investment?

Common sense seems to say that your average return must be exactly zero (=0) because you
started with $200 and ended with $200.

But if we calculate the returns year-by-year, we see that you lost 50% the first year (you lost
half of your money). The second year, you made 100% (you doubled your money).

 Your average return over the two years was (−50% + 100)/2 = 25%!

Which is correct, 0 percent or 25 percent? Both are correct: They just answer different
questions. The 0 percent is called the geometric average return. The 25 percent is called the
arithmetic average return.

- The geometric average return answers the question, “What was your average
compound return per year over a particular period?”
- The arithmetic average return answers the question, “What was your return in an
average year over a particular period?”

1. Arithmetic average return – Định nghĩa, công thức: (Phần của My iu)

* Definition of Arithmetic average return:

- The Arithmetic average return formula (also known as arithmetic mean return) is
the average that you are most familiar with. It is defined as a return earned in an
average period over multiple periods. That means the arithmetic average tells
you what you earned in a typical year.
- The arithmetic average return is not usually an appropriate method for
calculating an average. Because, in this formula, each return independent of the
other - It’s very important. That means the arithmetic mean return ignores
 the compounding effect and order of returns and it is misleading when the
investment returns are volatile.
- The arithmetic average return overstates the true return of the investment and
should only be used for shorter time periods.

* Formula of Arithmetic average return:

Arithmetic average return can be calculated using the following formula:

R 1+ R 2+ …+ RT
Arithmetic Average =
T

Where:

R1, R2, …, RT : Portfolio returns for period T

T: Number of periods

- An arithmetic average is the sum of a series of numbers divided by the count of that
series of numbers. Which means, to calculate the arithmetic average, you have to sum
up each year’s return and then divide them by the number of returns you have.
- Unless it’s stated, otherwise this is the average return that they provide you with.

=> This will tell you what you earned in a typical year over that time frame that you’re
evaluating.

* Example:

In order to understand more about the arithmetic average return, we can consider
investment returns, for example. Suppose you have invested your savings in the financial
markets for five years. If your portfolio returns each year were 90%, 10%, 20%, 30%, and
-90%, what would your average return be during this period?

- With the arithmetic average, the average return we have been calculating is (0.9 + 0.1 +
0.2 + 0.3 – 0.9) / 5, then number would be 12%, which appears at first glance to
be impressive—but it's not entirely accurate.
- That's because when it comes to annual investment returns, the numbers are not
independent of each other. If you lose a substantial amount of money in a particular
year, you have that much less capital to invest and generate returns in the following
years.
  Therefore, we need to calculate the geometric average of your investment returns to
arrive at an accurate measurement of what your actual average annual return over the
five-year period would be.

2. Geometric average – average compound return per period over multiple periods: Định
nghĩa, công thức

EXAMPLE 12.4 Calculating the Geometric Average Return Calculate the geometric average
return for S&P 500 large-cap stocks for the first five years in Table 12.1, 1926–1930. First,
convert percentages to decimal returns, add 1, and then calculate their product: S&P 500
Returns Product 13.75 1.1375 35.70 ×1.3570 45.08 ×1.4508 −8.80 × .9120 778 −25.13 × .7487
1.5291 406 Notice that the number 1.5291 is what our investment is worth after five years if we
started with a $1 investment. The geometric average return is then calculated as follows:
Geometric average return=1.52911/5−1=.0887, or 8.87% The geometric average return is about
8.87 percent in this example. Here is a tip: If you are using a financial calculator, you can enter
$1 as the present value, $1.5291 as the future value, and 5 as the number of periods. Then,
solve for the unknown rate. You should get the same answer we did.

* Definition of Geometric average return:

- The geometric average return formula (also known as geometric mean return) is
a way to calculate the average rate of return on an investment that is
compounded over multiple periods. Put simply, the geometric average return
takes into account the compound interest over the number of periods.
- What this means is that the geometric mean return is a better measure of the
average return on investment than the arithmetic average return which simply
adds the returns for each period together and divides them by the number of
periods.
- If you need to compare returns over an extended period of time the geometric
average return (GAR) is the better formula which accounts for the order of the
return and the compounding effect.

* Formula of Geometric average return:

- The geometric mean for a series of numbers is calculated by taking the product
of these numbers and raising it to the inverse of the length of the series.

- To do this, we add one to each number (to avoid any problems with negative
percentages). Then, multiply all the numbers together and raise their product to
 the power of one divided by the count of the numbers in the series. Then, we
subtract one from the result.

- The formula, written in decimals, looks like this: 

1
Geometric average return = [(1+ R1)×(1+ R2)×…×(1+ RT )] x −1
T

Where:

R1, R2, …, RT : Portfolio returns for period T

T: Number of periods

* Example:

Calculate the geometric average return for S&P 500 large-cap stocks for the first five years
in following table , 1926 – 1930. First, convert percentages to decimal returns, add 1, and
then calculate their product:

Year S&P 500 Returns (%) Product

1926 13.75 1 + 13.75% = 1.1375
1927 35.70 1 + 35.70% = 1.3570
1928 45.08 1 + 45.08% = 1.4508
1929 – 8.80 1 + (– 8.80%) = 0.9120
1930 – 25.13 1 + (– 25.13%) = 0.7487
1.1375 x 1.3570 x 1.4508 x 0.9120 x 0.7487 = 1.5291

Notice that the number 1.5291 is what our investment is worth after five years if we
started with a $1 investment. The geometric average return is then calculated as follows:

1.5291
Geometric average return= − 1= 0.0887, or 8.87%
5

The geometric average return is about 8.87% in this example.

(Here is a tip: If you are using a financial calculator, you can enter $1 as the present value,
$1.5291 as the future value, and 5 as the number of periods.

Then, solve for the unknown rate. You should get the same answer we did)

1.5291
1= => x= 0.0087
( 1+ x )5
3. Example: Computing Arithmetic and Geometric average:

What is the arithmetic and geometric average for the following returns?

Year Returns (%)

1 5
2 -3
3 12

5+ (−3 ) +12
• Arithmetic average = = 4.67%
3
• Geometric average = [(1+0.05) * (1-0.03) * (1+0.12)] 1/3 – 1 = 0.0449 = 4.49%

So, we look at what is the difference.

- Arithmetic average in this example is exactly what you’re used to. Independent returns
not based upon prior returns. We have 5 plus a negative 3 plus 10 plus 12, sum it up is
14, then divided by 3, so, arithmetic average is 4.67.

- Geometric average, on the other hand, creates the dependency upon prior year returns.
This is the one that is compound growth rate.

 On day 0 of a company, we start with 1. That’s the normal growth rate which is
not growing yet.
 In the first period, we have 5 percent growth over our base year, we have 1.05.
Then, 1.05 times 1 tells us that we had a 5% return in the first period.
 In the second year, we actually had a negative return. It’s no longer 1, it’s 0.97,
so 1.05 then it times 0.97.
 In the third year, it was 12 percent, more than what we did in year 2, so we’re
creating that dependency as we move through time. So now it’s 1.12 times 0.97.
 Therefore, we have 1.05 times 0.97 because we have 97%, less than what we were in
year 1, then times 1.12 because we have 12%, more than what we did in year 2. So, that
creats the dependency. 1.05 times 0.97 times 1.12, all of that get raised to 1 divided by
T- the number of observations, T is 3 in this case. And then we minus 1, and we get a
value of 0.0449 or 4.49%. That’s formula for the geometic mean.
 - Notice that the geometric average is slightly lower than the arithmetic, and it makes
perfect sense because that is the compound growth rate taking into consideration the
compounding year-over-year.

4. Compare geometric average will be less than the arithmetic average unless all the
returns are equal

Sách bản 12 According to above example, one thing you may have noticed is that the
geometric average returns seem to be smaller (than arithmetic average). This will always be
true (as long as the returns are not all identical, in which case the two “averages” would be
the same). The reason is that the difference is greater for more volatile investments.

In fact, there is a useful approximation. Assuming all the numbers are expressed in decimals
(as opposed to percentages), the geometric average return is approximately equal to the
arithmetic average return minus half the variance. For example, looking at the large-
company stocks, the arithmetic average is .120 and the standard deviation is .199, implying
that the variance is .040. The approximate geometric average is thus .120 − .040/2 = .100,
which is the same as the actual value in this case.

Comparative Table

Basis Geometric Mean Arithmetic Mean

Geometric Mean is known as the Multiplicative

Meaning Arithmetic Mean is known as Additive Mean.
Mean.

Geometric average return = [(1+ R1)×(1+ R2)×…

1
Formula ×(1+ RT )] x − 1 (Return1 + Return2 + Return3 + Return4)/ 4
T

The geometric mean is always lower than the The arithmetic mean is always higher than the
Values arithmetic means due to the compounding geometric mean as it is calculated as a simple
effect. average.
Basis Geometric Mean Arithmetic Mean

It is applicable only to only a positive set of It can be calculated with both positive and
Dataset
numbers. negative sets of numbers.

Geometric mean can be more useful when the This method is more appropriate when
Usefulness  dataset is logarithmic. The difference between calculating the mean value of the outputs of a
the two values is the length. set of independent events.

The geometric mean is used by biologists,

economists, and also majorly by financial The arithmetic mean is used to represent
Uses
analysts. It is most appropriate for a dataset average temperature as well as for car speed.
that exhibits correlation.

=> The use of geometric mean is appropriate for percentage changes, volatile numbers, and
data that exhibit correlation, especially for investment portfolios. Most returns in finance are
correlated like stocks, the yield on bonds, and premiums. The longer period makes the effect of
compounding more critical and hence also the use of a geometric mean. While for independent
data sets, arithmetic means is more appropriate as it is simple to use and easy to understand.

5. Blume’s formula – Lấy slide 1-32 Trung Tống gửi

Blume’s formula

 If the geometric average tends to be too high, and the arithmetic average too low, how
can we best estimate returns?

 Blume’s formula gives an unbiased estimate

 Suppose we calculate from N years of data and we wish to forecast future returns over T
years . Then forecasted returns R(T) are estimated as:

 R(T) = geometric mean*(T-1)/(N-1) + arithmetic mean*(N-T)/(N-1)

The problem we face is that we usually have only estimates of the arithmetic and geometric
returns, and estimates have errors. In this case, the arithmetic average return is probably too
high for longer periods and the geometric average is probably too low for shorter periods. You
should regard long-run projected wealth levels calculated using arithmetic averages as
optimistic. Short-run projected wealth levels calculated using geometric averages are probably
pessimistic. The good news is that there is a simple way of combining the two averages, which
we will call Blume’s formula.

Suppose we have calculated geometric and arithmetic return averages from N years of data,
and we wish to use these averages to form a T-year average return forecast, R(T), where T is
less than N. Here’s how we do it:

T −1 N −T
R(T) = Geometric average * + Arithmetic average *
N −1 N−1

For example, suppose that, from 25 years of annual returns data, we calculate an arithmetic
average return of 12 percent and a geometric average return of 9 percent. From these
averages, we wish to make 1-year, 5-year, and 10-year average return forecasts. These three
average return forecasts are calculated as follows:

1−1 25−1
R(1) = ( ) * 9% + ( ) * 12% = 12%
25−1 25−1

5−1 25−5
R(5) = ( ) * 9% + ( ) * 12% = 11.5%
25−1 25−1

10−1 25−10
R(10) = ( ) * 9% + ( ) * 12% = 10.875%
25−1 25−1

We see that 1-year, 5-year, and 10-year forecasts are 12 percent, 11.5 percent, and 10.875 percent,
respectively.

6. According to Blume’s formular, the circumstances under which one average is better?

- The arithmetic average is overly optimistic for long horizons

- The geometric average is overly pessimistic for short horizons
- So, the answer depends on the planning period under consideration
 15 – 20 years or less: use the arithmetic
 20 – 40 years or so: split the difference between them
 40 + years: use the geometric
- When we talk about average returns, we generally are talking about arithmetic average
returns.

I know the question is which one should we use and why shoud we use it. So, when we
think about how these different average return calculations work, we look at the
differences between the two models.
However, the problem we face is that we usually have only estimates of the arithmetic
and geometric returns, and estimates have errors. In this case, the arithmetic average
returnis probably “too high” for longer periods and the geometric average is probably “too
low” for shorter periods.
So, we should regard that:
- The arithmetic average, where the returns are independent of one another, is going to
create kind of an overly optimistic scenario we’re talking about periods of time over
long-time horizons, such as 20, 30, 40, or 50 years.
- If we look at the geometric mean, we kind of go the opposite direction, it’s overly
pessimistic, overly negative for the short-term horizons.
- So, the answer kind of depends upon what your planning horizons are, and what you’re
looking at trying to calculate.
 If we’re dealing with a historial period of time, that is 15 to 20 years or less than
that, then using the straight arithmetric average is totally fine.
 If we’re talking about a period of time of 20 to 40 years (as you might do for
retirement planning), then we can calculate the two, one arithmetic mean, one
geometric mean, and count average amount and use that
 And if we’re looking at a period of time that is greater than 40 years, then we’d
probably be better served using the geometric mean as our primary metric.
Because at that point, over a 40-year period of time, the returns they are
dependent upon one another.
For instance, the returns become dependent if you’re had a company that’s been
around for a hundred years. Decisions that have been made over periods of time
generate returns that are based upon prior returns. Therefore, over that long
time horizon, the geometric mean becomes more representative of the business
as a whole.
- This concludes our discussion of geometric versus arithmetic averages. One last note:
In the future, when we say “average return,” we mean arithmetic unless we explicitly
say otherwise.