Frequently asked questions
What is the difference between arithmetic and geometric average return?
Arithmetic average is the simple mean of yearly returns. Geometric average (CAGR) accounts for compounding and shows the actual annualized growth rate. The geometric mean is always lower than the arithmetic mean when returns vary, because volatility reduces compound growth. The geometric mean reflects what you actually earned.
Which average should I use for financial planning?
Use the geometric mean (CAGR) for projecting how an investment actually grew or will grow. The arithmetic mean overestimates long-term growth when returns are volatile. The arithmetic mean is appropriate only for estimating the expected return in any single future year.
Why is the geometric mean lower than the arithmetic mean?
Volatility drags down compound growth. If you gain 50% then lose 50%, your arithmetic average is 0% but you actually lost 25% (the geometric mean is about -13%). The more volatile the returns, the larger the gap between the two averages. This is called 'volatility drag.'
How do I interpret the standard deviation?
Standard deviation measures the spread (volatility) of returns around the average. A higher standard deviation means more unpredictable year-to-year results. Roughly two-thirds of years will fall within one standard deviation of the mean. Higher volatility reduces compound growth.
Can negative returns be included?
Yes, include negative years (e.g. -15 for a 15% loss). The only restriction is that no single year can be -100% or worse, because that implies a total loss after which the geometric mean is undefined. Real-world investments can't lose more than 100%.