Geometric or Arithmetic Mean: A Reconsideration
Posted: 26 Jan 2004
An unbiased forecast of the terminal value of a portfolio requires compounding of its initial value at its arithmetic mean return for the length of the investment period. Compounding at the arithmetic average historical return, however, results in an upwardly biased forecast. This bias does not necessarily disappear even if the sample average return is itself an unbiased estimator of the true mean, the average is computed from a long data series, and returns are generated according to a stable distribution. In contrast, forecasts obtained by compounding at the geometric average will generally be biased downward. The biases are empirically significant. For investment horizons of 40 years, the difference in forecasts of cumulative performance can easily exceed a factor of 2. And the percentage difference in forecasts grows with the investment horizon, as well as with the imprecision in the estimate of the mean return. For typical investment horizons, the proper compounding rate is in between the arithmetic and geometric values.
Keywords: Portfolio management, asset allocation, investment theory, portfolio theory, quantitative tools, econometric and statistical methods
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