Arithmetic Average Advantages and Disadvantages

Arithmetic average: the basic measure of central tendency

Arithmetic average, of arithmetic mean, or just mean, is probably the simplest tool in statistics, designed to measure central tendency in a data set (which can be a group of stocks or returns of a stock in particular years). Using arithmetic average has advantages and disadvantages, and in some cases you may find other measures (like geometric average or median) more suitable.

Advantage 1: Fast and easy to calculate

As the most basic measure in statistics, arithmetic average is very easy to calculate. For a small data set, you can calculate the arithmetic mean quickly in your head or on a piece of paper. In computer programs like Excel, the arithmetic average is always one of the most basic and best known functions (in Excel the function is AVERAGE). Here you can see the basics of arithmetic average calculation.

Advantage 2: Easy to work with and use in further analysis

Because its calculation is straightforward and its meaning known to everybody, arithmetic average is also more comfortable to use as input to further analyses and calculations. When you work in a team of more people, the others will much more likely be familiar with arithmetic average thangeometric average or mode.

Disadvantage 1: Sensitive to extreme values

Arithmetic average is extremely sensitive to extreme values. Imagine a data set of 4, 5, 6, 7, and 8,578. The sum of the five numbers is 8,600 and the mean is 1,720 which doesnt tell us anything useful about the level of the individual numbers. Therefore, arithmetic average is not the best measure to use with data sets containing a fewextreme values or with more dispersed (volatile) data sets in general. Median can be a better alternative in such cases.

Disadvantage 2: Not suitable for time series type of data

Arithmetic average is perfect for measuring central tendency when youre working with data sets of independent values taken at one point of time. There was an example of this in one of the previous articles, when we were calculating average return of 10 stocks in one year. However, in finance you often work with percentage returns over a series of multiple time periods. For calculating average percentage return over multiple periods of time, arithmetic average is useless, as it fails to take the different basis in every year into consideration (100% equals a different price or portfolio value at the beginning of each year). The more volatile the returns are, the more significant this weakness of arithmetic average is. Here you can see the example and reason whyarithmetic average fails when measuring average percentage returns over time.

Disadvantage 3: Works only when all values are equally important

Arithmetic average treats all the individual observations equally. In finance and investing, you often need to work with unequal weights. For example, you have a portfolio of stocks and it is highly unlikely that all stocks will have the same weight and therefore the same impact on the total performance of the portfolio. Calculating the average performance of the total portfolio or a basket of stocks is a typical case whenarithmetic average is not suitable and it is better to use weighted average instead. You can find more details and an example here: Why you need weighted average for calculating total portfolio return.

Conclusion
Arithmetic average as a measure of central tendency is simple and easy to use. But in order to take advantage of it and prevent it from doing any harm to your analysis and decision making, you should be familiar with the situations when it fails and when other tools are more useful.

ADVANTAGES
The mean uses every value in the data and hence is a good representative of the data. The irony in this is that most of the times this value never appears in the raw data. Repeated samples drawn from the same population tend to have similar means. The mean is therefore the measure of central tendency that best resists the fluctuation between different samples.[6] It is closely related to standard deviation, the most common measure of dispersion.
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DISADVANTAGES
The important disadvantage of mean is that it is sensitive to extreme values/outliers, especially when the sample size is small.[7] Therefore, it is not an appropriate measure of central tendency for skewed distribution.[8] Mean cannot be calculated for nominal or nonnominal ordinal data. Even though mean can be calculated for numerical ordinal data, many times it does not give a meaningful value, e.g. stage of cancer.

Advantages of the Geometric Mean The following are advantages of the geometric mean. Like the arithmetic mean, the geometric mean will detect outliers. Each value in the data set contributes to the geometric mean.

Disadvantages of the Geometric Mean The following are disadvantages of the geometric mean. In a data set containing a zero, the geometric mean will not work. The geometric mean is not a well known measure of center

Advantages of the Median The following are some advantages of using the Median to measure center. The median is not sensitive to outliers One half of the data is below the median and one half above. Disadvantages of the Median The following are some disadvantages of using the Median. Not every number is included in the computation of the median. The median is not as well known as the mean.

Advantages of the Arithmetic Mean The following are advantages of the arithmetic mean. The arithmetic mean is the standard measure of center. It is usually called the average. The arithmetic mean detects and is eected by outliers. Disadvantages of the Arithmetic Mean The following are disadvantages of using the arithmetic mean. The arithmetic mean is strongly aected by outliers and can

be skewed because of outliers. The arithmetic mean my not accurately represent the typical value of a data point.

Advantages and Disadvantages of the Mode Advantages: works well with non-numeric data, usually easy to nd, is the most typical data. Disadvantages: may not exist, my not be related to the real center of the data.