Difference Between the Arithmetic Mean and the Geometric Mean

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.

KEY TAKEAWAYS:

• The 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. The longer the time horizon, the more critical compounding becomes, and the more appropriate the use of the geometric mean.
• For volatile numbers, the geometric average provides a far more accurate measurement of the true return by taking into account year-over-year compounding.

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.

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