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Flashcards in Risk And Return Deck (6)
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Arithmetic and Geometric Averages

• Geometric average always less than or equal to arithmetic average


The Risk Premium For Arithmetic Returns

Average rate of return for equity minus risk free interest rate


When decisions are being taken on a forward-looking basis the
arithmetic mean (rA) is the appropriate measure

• Represents the mean of all the returns that may possibly
occur over the investment holding period
• Best estimator of expected (short-term) future return
• The best gauge of the expected risk premium
- Expected return above risk free interest rate


Has intuitive appeal from an investment perspective

• When past performance is being considered, the geometric
mean (rG) summarizes the annualized rate of return over a
historical period
• Best measure of realized (past) returns on an investment
• How fast has it grown on average?


6 Lessons From History about Risk and Return

• Equities were the best performing asset class in all sample
• Equities had highest risk
• Inflation was a major force in the 20th century
• Bond returns have been especially high since 1980 due to
declining interest rates
• Although equities performed best, equity returns were lower
than previous studies have reported
• The prospective real return on world equities has fallen to
around 3-3.5% per annum


Importance of Equity Risk Premium

• Investors demand compensation for
1. Abstaining from consuming today and waiting until tomorrow
• Gauged by the time-preference (price of time) – the risk free interest rate
2. Taking on risk – measured by the risk premium