Therefore, the Geometric mean shows the true picture of investment that there is a loss in investment with an annualized negative return of Since the return in each year impacts the absolute return in the next year, a geometric mean is a better way to calculate the annualized return on investment. When one needs to calculate the average of variables that are not dependent on each other, Arithmetic means a suitable tool to calculate the average.
The average of marks of a student for 5 subjects can be calculated by the arithmetic mean as scores of the student in different subjects are independent of each other. Such as calculating the average score of a student in all the subjects.
Geometric mean shall be used to calculate the mean where the variables are dependent on each other. Such as calculating the annualized return on investment over a period of time. Effect of Compounding The arithmetic mean does not take into account the impact of compounding, and therefore, it is not best suited to calculate the portfolio returns. The geometric mean takes into account the effect of compounding, therefore, better suited for calculating the returns.
Accuracy The use of Arithmetic means to provide more accurate results when the data sets are not skewed and not dependent on each other. Where there is a lot of volatility in the data set, a geometric mean is more effective and more accurate.
Application The arithmetic mean is widely used in day to day simple calculations with a more uniform data set. It is used in economics and statistics very frequently. The geometric mean is widely used in the world of finance, specifically in calculating portfolio returns.
Ease of Use The arithmetic mean is relatively easy to use in comparison to the Geometric mean. The geometric mean is relatively complex to use in comparison to the Arithmetic mean. Mean for the same set of numbers The arithmetic mean for two positive numbers is always higher than the Geometric mean.
The geometric mean for two positive numbers is always lower than the Arithmetic mean. Examples of this phenomena include the interest rates that may be attached to any financial investments, or the statistical rates if human population growth. Financial Times. Financial Analysis. Financial Ratios. Risk Management. Actively scan device characteristics for identification.
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What Is the Geometric Mean? Key Takeaways The geometric mean is the average rate of return of a set of values calculated using the products of the terms. Geometric mean is most appropriate for series that exhibit serial correlation—this is especially true for investment portfolios. Most returns in finance are correlated, including yields on bonds, stock returns, and market risk premiums. For volatile numbers, the geometric average provides a far more accurate measurement of the true return by taking into account year-over-year compounding that smooths the average.
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Investopedia does not include all offers available in the marketplace. Related Terms Arithmetic Mean Definition The arithmetic mean is the sum of all the numbers in the series divided by the count of all numbers in the series.
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