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The Haystack: What Do You Mean?
Schools may be closed, but it is finals week here at Monument. And here’s a computational nugget for the mathletes out there.
You are probably familiar with averages. Three children. Ages 3, 5, and 9. Average age = 5.7 years.
*Yawn*
And you are probably familiar with financial ratios – say, price-to-earnings (or P/E). A stock trades at a price of $100 with earnings per share of $10. P/E = 10x.
*Double yawn*
But how do you average P/E ratios? Say, the average P/E for a basket of stocks?
You own an equal amount of 3 stocks. One trading at 5x, another a 10x, and the last at 15x. The average of your basket is 10x, right?
The answer is 8.2x.
The arithmetic mean (from our first example above) gives undue weighting to extreme measures and will produce an overestimation. It is not equipped to deal with rates, or in this case, earnings yields.
The harmonic mean – and more specifically for a basket of stocks, the weighted harmonic mean – yields the accurate result.
But do not take my word for it. Let us use another real-life example.
Say you take a 5-mile trip or 10-mile round trip. On the way there, you travel 30mph. On the way back, you travel 10mph. Your intuition might be to say your average speed is 20mph. But alas…
• Leg 1 of your trip takes 10 minutes. Leg 2 of your trip takes 30 minutes. Forty total minutes.
• Leg 1 accounts for 25% of your trip, and leg 2 accounts for 75%.
• 0.25 x 30mph + 0.75 x 10mph = 15mph
• [1/10 + 1/30] / 2 = 1/15, and the reciprocal of 1/15 = 15…this is your harmonic mean!
The more you know!
Some of Wall Street’s Best Strategists Have Changed Their Outlooks–What Now?
There is nothing wrong with forecasting…it only becomes a problem when you try to draw your own conclusions (also a…
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All indexes referenced are unmanaged and cannot be invested into directly. The economic forecasts set forth may not develop as predicted. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Monument Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Monument Wealth Management is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.
A copy of Monument Wealth Management’s current written disclosure statement discussing our advisory services and fees is available for review upon request.
Erin M. Hay, CFA
Private Wealth Advisor, Portfolio Manager
A graduate of the University of Oklahoma, Erin began his investment management career with J.P. Morgan Private Bank. There, he worked with portfolio managers, traders and asset class specialists to bring tailored investment solutions to his team’s high net worth clients. However, intellectual curiosity would dictate both a change in geography and job description.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Monument Capital Management, LLC [“Monument”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Monument. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. No amount of prior experience or success should be construed that a certain level of results or satisfaction will be achieved if Monument is engaged, or continues to be engaged, to provide investment advisory services. Monument is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.
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