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RA = (HPR)/n = 40/5 = 8%
Geometric Mean Return
The geometric mean is the one return that, if
earned in each of the n years of an
investment’s life, gives the same total dollar
result as the actual investment.
It is calculated as the nth root of the product
of all of the n return relatives of the
investment.
RG = [(Return Relatives)]1/n – 1
Geometric Mean
Example
Year Holding Period Return Return Relative
1 10% 1.10
2 30% 1.30
3 -20% 0.80
4 0% 1.00
5 20% 1.20
RG = [(1.10)(1.30)(.80)(1.00)(1.20)]1/5 – 1
RG = .0654 or 6.54%
Arithmetic vs.
Geometric
To ponder which is the superior measure,
consider the same example with a $1000 initial
investment. How much would be accumulated?
Year Holding Period Return Investment Value
1 10%$1,100
2 30%$1,430
3 -20% $1,144
4 0% $1,144
5 20%$1,373
Arithmetic vs.
Geometric
How much would be accumulated if you earned
the arithmetic mean over the same time period?
Value = $1,000 (1.08)5 = $1,469
How much would be accumulated if you earned
the geometric mean over the same time period?
Value = $1,000 (1.0654)5 = $1,373
Notice that only the geometric mean gives the
same return as the underlying series of returns.
Scenario Analysis
While historic returns, or past realized
returns, are important, investment decisions
are inherently forward-looking.
We often employ scenario or “what if?”
analysis in order to make better decisions,
given the uncertain future.
Scenario analysis involves looking at different
outcomes for returns along with their
associated probabilities of occurrence.
Expected Rates of
Return
Expected rates of return are calculated
by determining the possible returns (Ri)
for some investment in the future, and
weighting each possible return by its
own probability (Pi).
E(R) = Pi Ri
Expected Return
Example
Economic Conditions Probability Return
Strong .20 40%
Average .50 12%
Weak .30 -20%