Geometric Mean
Candlefocus EditorThe geometric mean is most useful for evaluating different investments that have had extremely volatile performances over time, especially when the investment involves sums of money that are expected to increase over time. The geometric mean is especially helpful in determining the overall performance of a portfolio when the returns experienced have been volatile and have seeing both significant jumps and periods of stagnation. Higher volatility leads to a lower geometric means when compared to the arithmetic mean.
To calculate the geometric mean start with the simple formula, m = (x1x2x3x4…xn)1/n, where m is the geometric mean, x1 is the first return, x2 is the second return, and so on.
The geometric mean is particularly useful when looking at the average single-year return of a portfolio over multiple years. This is because the geometric mean takes into account potential compounding effects that may have occurred over the period of years and adjusts for them. In addition, the geometric mean is a better indicator of true risk-adjusted returns than the arithmetic mean.
In conclusion, the geometric mean is a powerful metric for measuring a return on a portfolio over multiple years. It takes into account volatility, compounding, and short-term fluctuations to provide a more accurate picture of the portfolio's performance than the arithmetic average does. The geometric mean is helpful for those looking to evaluate longer-term investments and understand their returns the best.