Thursday, July 23, 2009
ARITHMETIC VS. GEOMETRIC
What exactly is the Value Line Arithmetic Index ($VLE), and how does it differ from the Value Line Geometric Index ($XVG)? Both indexes are products of Value Line Inc., developers of the popular Value Line Investment Survey. The two indexes both consist of the approximately 1,700, equally weighted stocks that make up the investment survey. The principal difference between the two indexes, however, is the way that they are calculated. The Arithmetic Index consists of a simple mean or average in which the sum of the items is divided by the number of items. The Geometric Index, on the other hand, is a bit more complex. According to Value Line's description at www.valueline.com, the geometric average involves taking the nth root of the product of n items. If n = 4, then the geometric average of the four items would be the fourth root of the product of the four items — in other words, multiply the four items together and take the fourth root of that product.
What difference do these computation methods make on the respective indexes? Generally speaking, both Value Line indexes do a better job than the S&P 500 and Dow Industrials do at picking up the price action of smaller stocks. Because both averages are equally weighted.
One of the more particular aspects of the Arithmetic Index ($VLE) is that, based on the way the index is put together, it tends to advance farther than the Geometric Index (XVG) in a bull market and decline less in a bear market. This has led some to claim a preference for the Geometric Index, which is believed by its adherents to be a truer reflection of stock strength than its Arithmetic alternative.
*click on chart to expand image