There are many ways to measure financial portfolio performance and determine if an investment strategy is successful. Investment professionals often use the geometric average , more commonly called the geometric mean.
The geometric mean differs from the arithmetic average , or arithmetic mean, in how it is calculated because it takes into account the compounding that occurs from period to period.
Because of this, investors usually consider the geometric mean a more accurate measure of returns than the arithmetic mean. An arithmetic average is the sum of a series of numbers divided by the count of that series of numbers. If you were asked to find the class arithmetic average of test scores, you would simply add up all the test scores of the students and then divide that sum by the number of students.
This would be calculated as:. The reason we use an arithmetic average for test scores is that each score is an independent event. If one student happens to perform poorly on the exam, the next student's chances of performing poorly or well on the exam is not affected. In the world of finance, the arithmetic mean is not usually an appropriate method for calculating an average. Consider investment returns , for example.
Suppose you have invested your savings in the financial markets for five years. 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. 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.
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:. The formula appears complex, but on paper, it's not so difficult.
The geometric mean is more suitable for calculating the mean and provides accurate results when the variables are dependent and widely skewed. However, an Arithmetic mean is used to calculate the average when the variables are not interdependent. Therefore, these two should be used in a relevant context to get the best results. This has been a guide to the top difference between Geometric Mean vs Arithmetic Mean. Here we also discuss the Geometric Mean vs Arithmetic Mean key differences with infographics and comparison table.
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