The stock market goes up and down. Suppose its level alternates each year between 50 and100, with no upward or downward trend. What is the capital return on the market?
Common sense suggests the answer is zero. But is that common sense right? In the good yearsyou obtain a return of 100 per cent. In the bad, the yield is minus 50 per cent. The averagereturn is therefore 25 per cent. There is logic to that. If you invested the same amount everyyear, and sold at the end of a year, you would indeed make – on average – a very attractivereturn of 25 per cent a year.
What if you bought and sold at random? In that case, four options are equally likely: buy andsell at 50, buy and sell at 100, buy at 50 and sell at 100, buy at 100 and sell at 50. Theoverall annual expected gain is 12.5 per cent.
If you are by now thoroughly confused, you are not alone. The average historic return on thevolatile equity market is central to calculations of the cost of capital and provision for futurepension liabilities. But the figure has been debated for decades. The dispute is less about theunderlying data than about the way you make the calculation. The question is often framedas the choice between arithmetic and geometric means.
But there is no right or wrong answer. In all problems of this kind, the relevant measure isspecific to the particular purpose you have in mind.
The way we measure inflation is, in principle, straightforward too.
You take an everyday basket of household goods and send a mystery shopper to discover whatthe bundle costs. Then you do the same thing a month later and find out how much the price ofthe basket has increased. You revise the composition of the basket regularly to introduce newgoods and eliminate obsolete ones, and to respond to changes in the composition ofspending.
But every month some of the goods are on special offer. Perhaps you can buy one bottle ofshampoo and get one free. The price of shampoo has fallen by 50 per cent but you spend thesame and get two bottles. Then the offer ends, and the price has risen by 100 per cent.
If you spent the same on shampoo and conditioner, and then the price of shampoo fell by half,and the price of conditioner doubled, we would probably want to say that the cost of washingyour hair has gone up.
What happens in practice depends on the detail of the instructions to the mystery shopper andthe frequency with which the relative weights of the components of the basket are reassessed.