Financial Management: Principles and Applications, 13/e

7.3 Geometric Versus Arithmetic Average Rates of Return

When evaluating the possibility of investing in a security or financial asset such as those discussed in the previous section, investors generally begin by looking at how that investment performed in the past, often over the course of many years. It is common to summarize the past returns as a yearly average. For example, if you held a stock for two years that realized a rate of return of 10 percent in the first year and 20 percent in the second year, you might simply add the two rates together and divide by two to get an average rate of 15 percent. This is a simple arithmetic average return. However, as we will describe, the actual return you realized from holding the stock for two years ...