Solved – Difference between geometric and arithmetic mean

arithmeticfinancegeometric meanmean

I still have problems to exactly understand the difference between geometric and arithmetic mean. I know that e.g. for returns, the arithmetic mean can be wrong (e.g. if I start with 100 $ and if my stock then goes up +10%, and then from 110 it goes down -10%, the mean of the return would be 0, however there is a loss).

So I know the problem lies in the fact, that the arithmetic mean "rewards" volatility. But why is this so. Can you explain in simple words, why the arithmetic mean is not appropriate for the example in brackets and why the geometric mean is the better measure?

Best Answer

e.g. if I start with 100 $ and if my stock then goes up +10%, and then from 110 it goes down -10%, the mean of the return would be 0,

This is not necessarily about arithmetic or geometric mean. This is also about simple or continuous return. Consider this:

$100(1+0.1)(1-0.1)=100(1-0.01)=99$

$100 e^{0.1}e^{-0.1}=100$

In the first case I assumed that your 10% return is a simple return. In the second case I assumed it's continuous return. Both are used a lot in finance in different situations.

Going back to the arithmetic and geometric returns, the rule of thumb is that if you're using the return for a single period forecast, then you use arithmetic return. If you're using it for multi period return, i.e. with compounding, use geometric return. This is not an absolute rule like NEwton's law of mechanics, of course

Related Question