We’re in a bit of a tizzy because we don’t know what to believe!
It all started last week when a fund manager type gave us brief presentation. He showed us an in-house “work in progress” giving the returns of various asset classes over a 30 year period. Alongside each asset class were two different average annual growth rates, which I thought odd so I asked him for an explanation. “Too complicated for me old chap” came the reply, “but one is the arithmetic mean and the other is the geometric mean”.
What are they? Well if you started with £100 and in year one it fell to £80, you would have suffered a 20% fall. If in year two it recovered up to the original £100 it would have grown by 25%. A fund manager might claim that minus 20% in year one followed by a plus 25% in year 2 means an overall gain of 5% approximately equivalent to 2.5% per year. This in simple terms is the arithmetic mean.
The geometric mean takes the same start and end figures but would conclude that to, start with £100 and end with £100 the average rate of return would be 0%. OK so this is a very simplistic exercise but it illustrates a point.
My concern is that the arithmetic mean figures for various investment indices show deliciously high average annual returns, perhaps enough to encourage inexperienced investors that it was a risk worth taking for such high average returns.
Eventually we received a copy of the “work in progress” which had been turned into a “sales aid”. Funnily enough the average rates of return for the various indices was only represented by their arithmetic mean – thus overstating the actual returns that might have been achieved by investors.
Fortunately for our clients, when we undertake our analysis we use the geometric mean.
