Question: The table below has price data and daily return data for Vanguard fund VB. Calculate the arithmetic and geometric averages of the daily return data. Show that the geometric average accurately reflects the relationship between the initial and final stock price and the arithmetic average does not accurately explain this relationship.
|Daily Price and Returns For Vanguard
|Date||Adjusted Close||Daily Return|
Analysis: The table below presents calculation of the two averages and the count of return days. The product of the initial value of the ETF, the pertinent average and the count of return days is the estimate of the final value. Estimates of final ETF value are calculated for both the arithmetic average and the geometric average and these estimates are compared to the actual value of the stock on the final day in the period.
|Understanding The Difference Between Arithmetic Mean and Geometric Mean Returns|
|Arithmetic Average of Daily Stock Change Ratio||1.001506208||Average function|
|Geometric Average of Daily Stock Change Ratio||1.001479966||Geomean function|
|Count of Return Days||21||Count Function|
|Estimate of final value based on arithmetic average||119.1889153||Initial Value x Arithmetic Return Average x Count Days|
|Estimate of final value based on geometric average||119.12335||Initial Value X Geometric Return Average x Count Days|
|Ending Value||119.12335||Copy from data table|
There is another way to show that the daily return should be modeled with the geometric mean rather than arithmetic mean. The average daily return of the stock is (FV/IV)(1/n) – 1 where FV is final value and IV is initial value and n is the number of market days in the period, which for this problem is 21.
Using this formula we find the daily average holding period return is 0.001479966. Note that 1 minus the geometric mean of the daily stock price ratio is also 0.001479966.
The geometric mean gives us the correct holding period return.