Abstract
Rates of Return over Multiple Periods, typically quarters are expressed as: Arithmetic Average of the quarterly returns, is the total return divided by the number of quarters. It ignores the compounding effect. Geometric (time weighted) Average of the quarterly returns, is equal to the single period return that would give the same performance as the actual return of the multiple periods. It ignores the quarter to quarter variations in the value of the funds under management The geometric average is always less than the arithmetic average because it takes into account, compounding. This does not mean that the arithmetic average is not useful. The arithmetic average is probably a better predictor of future performance. When the time periods and/or returns are small, adding or averaging rates of returns will give similar answers as compounding them. The arithmetic or geometric average do not have to be used for annual averages only. They can be used for any period of any length. An annual length is one of the most common. Dollar Weighted Return considers investment as a Capital Budget problem of cash outflows and inflows associated with a 'project'. Dollar Weighted Average Return is based upon the Internal rate of Return calculation. In other words, it is the discount rate that causes the present value of the future cash flows to be equal to the investment amount.
