Differences between Arithmetic, Geometric, and Harmonic MeansOct 1st, 2010 | By Andrew Matuszak | Category: Applied Finance, Lead Story
Although the concept of an average seems simple, we continue to see many people using an incorrect method to calculate averages. We would be surprised if most people were familiar with the three different types of averages mentioned in the title. In fact, many people (including journalists) routinely use the wrong type of average–leading to incorrect results and often poor decisions.
In this article, we will explore each of these averages and discuss when to use each. We will avoid mathematical derivations since most people will be using a spreadsheet.
For this article, we use Microsoft Excel to solve for the arithmetic, harmonic, and geometric means. However, we’ve also create an article that shows how to use the R software to calculate the various averages as well as compare them using graphs. We encourage you to read this article as well as it provides additional context that may be helpful in understanding the key differences between these averages.
The arithmetic mean is by far the most common average. It is the simplest to compute and the easiest to understand. In fact, most people are only familiar with the arithmetic mean; however, this is often inaccurate and misleading.
To illustrate the arithmetic mean, consider the three bars below.
The arithmetic mean is simply computed by adding the three heights together and dividing by three; the result is an average height of 3 feet.
In many instances, this is the correct type of average to use. The arithmetic mean is best used in situations where:
- the data are not skewed (no extreme outliers)
- the individual data points are not dependent on each other (see the section below for examples of where data are interrelated, e.g., financial analysis)
Probably the least understood, the harmonic mean is best used in situations where extreme outliers exist in the population. The harmonic mean can be manually calculated; however, most people will find it much easier to just use Excel. In Excel, the harmonic mean can be calculated by using the HARMEAN() function. If you interested in using R to calculate the harmonic mean, please visit here.
There are plenty of online resources (see Wikipedia) that cover the mathematical derivation of the harmonic mean; we are going to focus on when one should use it.
If the population (or sample) has a few data points that are much higher than the rest (outliers), the harmonic mean is the appropriate average to use. Unlike the arithmetic mean, the harmonic mean gives less significance to high-value outliers–providing a truer picture of the average.
For example, let’s consider how we could calculate the average height of the following bars.
In this population, there are 13 bars that are fairly similar in height and 1 bar that is more than 3 times larger. This outlier has a large effect on the arithmetic average, resulting in an average that is biased due to that one bar. If the objective is to calculate the average that most representative of the population, than the harmonic average is the best approach.
The harmonic average is less biased due to a small number of outliers. In the example above, the arithmetic average is approximately 47.7 while the harmonic average is approximately 41. In this case, the arithmetic average overstates the average by over 15%. The harmonic average provides a better picture of the true average of this population, discounting the large outlier.
The harmonic average is best to use when there is:
- A large population where the majority of the values are distributed uniformly but where there are a few outliers with significantly higher values
The geometric average should be used much more frequently than we suspect it is, especially when discussing average investment returns or interest rates.
Use the geometric average should be used whenever the data are inter-related–for example, when discussing returns on investment or interest rates. Using the arithmetic average will result in the wrong answer in these cases. Let’s consider an example.
An investment has the following returns over the next five years:
The simple arithmetic average is 12%. However, this is not correct. To understand why it is not correct, consider an initial investment of $10,000.
If one were to use the arithmetic average, they would arrive at an amount at the end of 2014 of $17,623.42. To confirm this, type the following formula into Excel:
This is incorrect. The table below illustrates the actual cash flows from the investment above.
The investment is actually worth $17,010 at the end of the five years. The arithmetic mean overstated the return by almost 4%. The correct mean to use in these situations is the geometric mean. To calculate the geometric mean in Excel, simply enter the annual returns and use the GEOMEAN function.
|1||Column A||Column B|
|7||Geometric Mean Function||=GEOMEAN(B2:B6)|
The geometric mean is approximately 11.20924. Confirm that this is the correct answer by typing the following formula into Excel:
The result is approximately $17,010 (slightly off due to rounding).
NOTE: When entering percentages in Excel for use in calculating the geometric mean, they must be entered as (1+percentage). For example, enter 40% as 1.40 and not .40. Similarly, a percentage of -20% would be .80.
If you are interested in using R to calculate the geometric mean of a sample of observations, please find here.
Choosing the correct mean is essential to correctly estimating the central tendency of a population or calculating investment returns. Although the concept of an average may seem simple, it is imperative for a user to carefully consider which mean to use–and to communicate to reader or intended audience the method of deriving the average and the rationale for doing so.