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A comprehensive explanation of the difference between geometric return and

arithmetic return and how to use this to analyze the published returns and
performance of both current and potential investment products you may own or
consider owning such as mutual funds and stocks. An example and a breakdown are
included in order to highlight the difference in the two types of returns.

Geometric Return vs. Arithmetic Return - Understanding the Difference in


Managing Your Investments

When analyzing investment returns it is important to differentiate between the simple


arithmetic return and the geometric return (a.k.a the average annualized rate of return or
compound average growth rate). The geometric return is the more accurate as it is the
average compounded return. The arithmetic average is always higher than the geometric
average, hence the arithmetic average return is usually the one posted in ads for mutual
funds and other investments. The only time when the arithmetic and geometric average
will be the same is when the individual returns being averaged are the same for each
period being analyzed.

Example1:

Mutual Fund XYZ has the following returns for the past 2 years:

Year 1: -20%
Year 2: +20%

This is a rather simplistic example, but its purpose is to illustrate our point. On the
surface it would appear that this fund has essentially "broken even" for the past 2 years.
The average return for the two years being evaluated is 0%. So; a $10,000 investment at
the beginning of year 1 is still worth $10,000 correct? Not quite. Even though the
arithmetic average return is 0%, the geometric return tells a different and more accurate
story.

Before we get into the formulas, let's just break down this example:

Year 1: $10,000 invested. The fund is down 20% by year end. The original investment
is now worth $8,000 [10000 x (1-.20)]

Year 2: You start with $8000. The fund is up 20%. Your investment at the beginning of
year 2 has grown to $9600 [8000 x (1+.20)]

This does not quite get you back to the original $10,000 invested at the start of Year 1
and is obviously not the break-even scenario it appeared to be initially. At the end of
year 2 you are actually down 4%.
Example 2:

Mutual Fund XYZ has the following returns for the past 3 years:

Year 1: -20%
Year 2: +20%
Year 3: +15%

The simple arithmetic return would be15% over the 3 years being evaluated, which
averages out to a 5% return per year. As we saw with the previous example, this is not
an accurate reflection of the true return on this investment for the past three years.

A 5% return per year would look as follows:

Year1: $10,000 * 1.05 = 10,500


Year2: $10,500 * 1.05 = 11,025
Year3: $11,025 * 1.05 = 11,576.25

We know from the first example that based on the returns for years one and two, we
would be starting year three with only $9600, so the 5% per year return scenario above
cannot be accurate.

Geometric Average Return

To get the geometric average return, we need to first obtain the total return:

Total Return = (1 + percent return) * (1 + percent return) * (1 + percent return)


(1-.20) * (1+.20) * (1-.15) = 1.104

Geometric average return = ((total return) ^ (1/number of years)) - 1


((1.104) ^ (1/3))-1 = .03353

You can check this in two ways:

Using the total return:


Year 1: $10,000 x (1-.2) = 8,000
Year 2: $8,000 x (1+.2) = 9,600
Year 3: $9600 x (1+.15) = 11,040

The result of the Total Return formula just above is 1.104.


10,000 (initial investment) x 1.104 = $11,040
The next way to check this is to use the Geometric average return within the formula for
compound interest.
P * ((1+r)^n)-1

P= Principal
r = geometric return
n = number of periods (years in this case)

10000 * ((1+.03353) ^ 3)-1 = 11,040

The key take away from all of this is for you to be able to draw a distinction between the
geometric average return and the arithmetic average return, and why it matters. Look
beyond the publicized investment returns being touted by the advertisers or investment
managers of the products being solicited. Ensure that you fully understand how these
investment returns translate in terms of the balances in your personal portfolio.
Additionally; take a more critical approach when analyzing potential investments and
their historical returns. Knowing the 'average' return of an investment is not very useful
unless you are able to differentiate between the arithmetic average return and the
geometric average return.