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The Haystack: What Do You Mean?

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?

via GIPHY

The answer is 8.2x.

via GIPHY

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!

 

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Erin M. photo

Erin M. Hay

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.

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IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative 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.

Please remember that if you are a Monument client, it remains your responsibility to advise Monument, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. 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 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’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at https://monumentwealthmanagement.com/disclosures/. Please Note: IF you are a Monument client, please advise us if you have not been receiving account statements (at least quarterly) from the account custodian.

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