The difference between the geometric and arithmetic return...
The difference between the geometric and arithmetic return...
Remember Warren Buffet's 2 rules for investing: Rule #1 is Don't lose money and Rule #2 is Don't forget the first rule. Why is this so important? Because as you lose money, the return you require to get back to "even" gets larger and larger.
To put numbers to it (approximating):
--a 10% loss requires 11% gain to get to even
--a 20% loss requires 25% gain to get to even
--a 30% loss requires 43% gain to get to even
--a 40% loss requires 67% gain to get to even
--a 50% loss requires 100% gain to get even
Think about it in simple terms. If you started with $100 and lost $50 dollars, that is a 50% decline. Do you need to earn 50% to get back to the $100 you started with? No, that would be earning only $25 back. You need to earn 100% on that $50 to go from $50 to $100. This is why mitigating losses is so important in portfolios and something to never lose sight of.
If you want a more accurate annual return of an investment, the geometric return (or compounded annual growth rate) will always provide a more accurate assessment of an investment's performance over a particular holding period compared to the arithmetic average. The geometric return will never be higher than the arithmetic average, because of its compounding effect.
Let's take a look at the following annual returns over a 5-year period to see the difference: 1) 5% 2) 20% 3) -35% 4) 50% 5) 10%
The arithmetic return is simply all of those annual returns added up and divided by 5, which equals an average return of 10%.
The geometric return (aka compounded annual growth rate) gets hit harder by declines, which is what happens in reality. That 35% loss in year 3 hurt this portfolio badly, and the geometric return, or CAGR, is only 6.2%.
Just remember Warren Buffet's rules for investing and you'll be fine. #CAGR #warrenbuffett #investing #wealthtipwednesday
Consult a financial advisor for more best practices.
-Your friends at Red Oak Financial Group