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In 2022, the market experienced an 18 percent decline, followed by a 24 percent increase in 2023. While you might believe these averages result in a positive six percent total return, the actual geometric average is around +1.7 percent per year.READ THE ARTICLE
Why the confusion? The analogy of Austin, Texas, temperatures illustrates that averages can be misleading. Although Austin averages 72 degrees, the temperature can vary significantly. Similarly, in investing, volatility around an average can erode returns. For example, achieving an eight percent average return doesn't guarantee consistent growth, as different sequences of returns can lead to vastly different outcomes.
Geometric vs. arithmetic: To accurately gauge your “average return”, you should know the difference between geometric average versus arithmetic average. The arithmetic average treats all values equally, while the geometric average considers the compounding effect and is more suitable for growth rates over time. From an investment standpoint, the arithmetic average is used for simple returns, while the geometric average is used for compound returns, providing a more accurate representation of investment performance over multiple periods.
Your average return matters, but more than that, how you average matters.