Question

You have calculated the historical dollar-weighted return, annual geometric average return, and annual arithmetic average return. You always reinvest your dividends and interest earned on the portfolio. Which method provides the best measure of the actual average historical performance of the investments you have chosen?

Answer 1

Answer: Geometric average return

Explanation: The geometric average return, also known as the geometric mean return is used to calculate the average rate for a particular period on an investment that is compounded over multiple periods. There is a formula to calculate this which is used specifically for investments that are compounded over multiple periods such as reinvesting dividends and interest earned on a portfolio as well as the principal.

The geometric average return takes into account the compounding (reinvestment) that takes place from period to period, which is why investors usually consider the geometric mean a more accurate measure of returns than the arithmetic mean.

Answer 2

Answer:

arithmetic average return

Explanation:

The arithmetic average return is often best used in short periods (from 1 to 5 years) to make investment returns forcasting. A differentiating factor of this method is that it ignores the compounding effect and order of returns and thus could provide misleading forcast numbers when the investment returns are volatile.

Therefore, it may not be reliable if used for longer periods like 10 years and above.