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Flashcards in Risk And Return Deck (6)
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1

Arithmetic and Geometric Averages

• Geometric average always less than or equal to arithmetic average
rG

2

The Risk Premium For Arithmetic Returns

Average rate of return for equity minus risk free interest rate

3

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

4

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?

5

6 Lessons From History about Risk and Return

• Equities were the best performing asset class in all sample
countries
• 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

6

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