Wednesday, December 16, 2009

An Early Christmas Gift to my Engineering Friends! The Difference Between Arithmetic and Geometric Averages in Finance?

What is the Average rate of return? For most people this is the very question that will determine whether or not they put their money in a particular investment. How someone determines that average rate of return number however can tell a completely different story about the investment. The link below talks about the difference between arithmetic and geometric averages. Arithmetic averages are what most of us used to use to determine our grade in school. However, in finance arithmetic averages can hide the true performance of an investment.

If someone is trying to sell you on an average rate of return be sure to ask them if they calculated that using an arithmetic or geometric average (and probably watch their eyes glaze over).

The formula below shows how to calculate an annual geometric compound average rate of return on an asset invested as a single lump sum (this is only for lump sums, and would not work for something you are making ongoing deposits, like a 401k).

(((Current Asset Value/Original Asset Value)^(1/Number of Years Compounding))-1)*100= Average Percentage Compounded Return

As an example say you originally had $100,000 in an IRA 8 years ago and today it is worth $150,000. Your average annual compounded rate of return is 5.1990%

See the Article Below for the Difference Between Arithmetic and Geometric Averages: