Investing - Theory, News & General • Total Portfolio Allocation and Withdrawal (TPAW)

Hi Ben - In the expected return section, should the input be the geometric return? Are the historical returns shown the geometric or arithmetic mean?

The expected return input for Merton's formula should be the arithmetic, not the geometric mean. The expected return input in TPAW is the arithmetic return. The historical returns option in the Expected Returns and Volatility section is the arithmetic mean of the historical sequence.

The arithmetic mean will correspond to the expected outcome of the simulation, and the geometric mean will correspond to the median outcome of the simulation.

More about arithmetic vs geometric mean here.

I think the use of arithmetic returns is confusing for the users. Most investors let their portfolio compound over time. Geometric returns (CAGR) make more sense for them. Multi-periods returns are by nature multiplicative. It's also common practice in capital market assumptions from financial institutions to use annualized (ie geometric) returns. Regardless of what you use in Merton's formula, shouldn't the UI only show and ask for geometric returns ?

Statistics: Posted by Corentin — Mon Nov 25, 2024 7:35 am — Replies 1130 — Views 299643

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