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All right, so two things to keep in

mind and this are important things for
you to keep in mind and
you'll see in a minute why.
The first and remember if you actually
keep in mind the data that we've seen.
We highlighted already not
only that the arithmetic and
the geometric mean return
were different for
each of the countries that we're looking
at but also we looked at the pattern.
And the pattern was that
that arithmetic mean return
was higher than the geometric mean return.
Now, strictly speaking,
if you want to be mathematically correct,
what we can say for sure is the arithmetic
mean return is higher than or
equal to the geometric mean return.
Now, I am saying that's only
to be mathematically correct,
because strictly speaking
that is the case.
Now if you really think about it,
there's only one circumstance
in which the arithmetic and the geometric
mean are going to be the same number.
And that is when you get the same
return over and over and over again.
So for example, you buy an asset and
you get 10%, 10%, 10%, 10%, 10% for
all the periods that you're looking at.
Then when you calculate the arithmetic and
the geometric mean return
they're going to be the same.
And I'm saying that well, that's not very
interesting because none of the assets
that we work within finance
actually have that characteristic.
They typically fluctuate over time and
whenever you have fluctuation
in the value of an asset.
However in legal that implies
a difference between the arithmetic and
the geometric mean return.
Now, characteristic number two.
The difference between the arithmetic and
the geometric mean return,
which as we said before is
always a positive difference.
Is increasing in
the variability of the asset.
In fact it is increasing in
the volatility of the asset.
But since we haven't yet
defined volatility, I'm not going to
try to use that word just yet.
So think about, that depending on

how much assets fluctuate over time,

the higher that fluctuation,
the larger it's going to be the difference
between the arithmetic mean,
and the geometric mean.
And let me give you an example
that would actually highlight
why that is actually important.
So, this is actually a very,
an asset with very little risk.
And that asset with very little risk,
as you see in there,
these are one year US Treasury Bills.
And basically, they have no risk.
They will not give you
a whole lot of returns, but
they will not actually
scare you along the way.
So as you see in those numbers that are in
front of you between 2004 and 2013, all
the numbers have been positive, sometimes
a little higher, sometimes a little lower.
But you haven't got any huge returns,
you haven't got any huge
disappointments either.
Now, If you add up all those returns and
divide it by ten,
which is the number of
returns that we have there,
then you're going to get
an arithmetic mean return of 1.95%.
If you calculated the geometric
mean return instead then what
you're going to get is 1.93%
a difference of two basis points.
Remember if you haven't ever heard
about the concept of basis points,
100 basis points is equal to 1%.
So that basically means that
two basis points is .02%.
And if all the differences between
arithmetic and geometric mean of return
were of that size, then we wouldn't worry
too much the difference between the two.
But, we do need to worry, and here is why.
Let's consider now the Russian market.
Now I should clarify that this
is a Russian equity market,
and as you see there, I don't need to tell
you much about the risk of this market.
In some periods, you actually
more than doubled your capital.
In some periods,
you lost about 80% of your capital,
in some other periods you lost
about one-third of your capital.
A market with huge variability,
with huge volatility,
with huge fluctuations in returns,
from very positive to a very negative.

Here comes the interesting thing.

Let's look, first,
the whole period that we have there in
terms of returns between 1995 and 2004.
If we were to calculate the arithmetic
mean return, we would get a huge number,
52.5%.
Now, let's suppose the following scenario.
Find someone who wants you
to buy Russian equities.
So here is a story that I tell you.
Look you should be investing
in Russian equities and
the reason is this between
the years 1995 and 2004 the mean
annual return of the Russian
equity market was over 52%.
I haven't lied to you.
I really haven't lied to you.
The problem is that I
gave you the incentive
to run the following calculation.
That is, I gave you the incentive to
think, well if I had started with a $100
at the beginning of 1995, and
my money had compounded at 52.5%.
Over ten years,
I would have ended with over $6,800.
So I started with $100.
I ended up with $6,800.
I multiplied my capital by
68 times in only ten years.
That's fantastic.
I do want to invest in
the Russian market now.
What's the problem with that?
Well, remember,
[COUGH] the arithmetic mean return
number doesn't tell you at which
rate your money evolved over time.
What tells you that is
the geometric mean return.
And guess what?
When we calculate the geometric
mean return is 18.4.
Now, 18.4 is a great number.
I mean, we would like to get many assets
in our portfolios in which we get 18.4%
per year over ten years and we probably
will not be able to find all those many.
But the thing is that 18.4 is far,
far lower than 52.5% per year.
And as a matter of fact, when you
compound 18.4 over ten years had you
started with $100 at the beginning of 1995
at the end of 2004 you would have $542.
Now $542 is still a great return but
of course its far far lower than $6,800.
So that means that what really happened to
your money is that it evolved at 18.4% per

year over ten years, and

your capital went from $100 to $542.
Again, that may be a very good rate
of return for those ten years, but
it's far, far lower than the $6,800
that I led you to believe.
Now this is why the difference
between the arithmetic mean and
the geometric mean is important.
If I don't tell you, if I'm a little
wishy-washy, if I'm not very specific
about what I mean by mean return, then I
maybe actually lying to you without lying
to you because I haven't lied when I say
that the mean annual return was 52.5%.
I was just a little wishy-washy.
So, to give you the incentive,
to run a calculation that is
actually not the correct one.
Now, it actually gets worse than that and
the reason it gets worse
than that is the following.
Let's focus now on that period,
that shorter period between 1995 and 1998.
Now let's look at the period
between 1995 and 1998.
What we see there, is that if we
calculate the arithmetic return of
those four numbers
are 38.7% just under 39%.
And again lets suppose and lets go back
to our hypothetical story that, for
whatever reason, I want you to invest
in Russian equites, and I tell you look
between 95 and 98, the mean annual
return on this market was almost 39%.
And I'm not lying to you.
The numbers would back up that
the mean annual return is 38.7%.
But at the same time that I'm not lying
to you, I'm not being very specific, and
I give you the incentive
to run that calculation.
That had you started with a $100
at the beginning of 1995 and
obtain those four returns between 95 and
98 at the end of that period you would
of ended with $371 in your pocket.
What's the problem with that?
Well, that if you calculate
the geometric mean return,
that number was actually minus 9.7%.
That means that you almost lost 10%
per year on an compounded basis.
And I'm not lying to you there, either.
You can actually calculate
those two numbers and remember,
the relationship between
the arithmetic and
the geometric mean is such that

the first is higher than the second.

But being higher than the second does not
prevent the situation in which the first
is positive and the second is negative.
As it is the case here with
the Russian market between 95 and 98.
So we have a very large and
positive arithmetic mean return and
an awful and
negative geometric mean return.
So your money actually lost at the mean
annual rate of almost 10% per year,
which means that you started
the year 1995 with $100 and
you ended the year 1998
with $67 in your pocket.
And that happened with
an arithmetic mean return of 38.7%.
So I sort of rest my case in
terms of trying to impress on you
the importance of the difference
between these two types of return.
They're very different because
they answer different questions,
they're numerically different, and one can
tell you that you're actually making money
over time, but the other may show you
that you're losing money over time, or
you're making a lot less money than you
thought you were making to begin with.
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