Demeaned returns are the stream of returns over a measurement period after subtracting the mean return over the period. Demeaned returns are used for the calculation of variance, standard deviation, covariance and correlation. The length of the measurement period is thus an important input in the evaluation of risk.
Pat: Why does Guy harp on the importance of
demeaned returns ?
Wes: Knowing him, he's likely upset that nobody else remembers linear algebra and portfolio theory.
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Demeaned returns definition for investment modeling (4:17)
The script includes two sections where we visualize and demonstrate the calculation of demeaned returns.
We're sitting here in Excel, and this is a snippet from our boot camp course.
The best way to visualize demeaned returns is to walk thorugh the four primary risk measures.
First, let's look at the calculation of variance and standard deviation, and at the end of the video there is a link so you can see this in detail. The demeaned returns for two stocks Microsoft and eBay sit in columns J and K.
In the second table, for covariance and correlation, J and K are identical.
Let's walk through a calculation for two stocks, Microsoft and eBay. We have six monthly returns for each stock from April to September 2003. Column F is the return on Microsoft, eBay is in column G.
Next, we compute the average for each, here 2.38% for Microsoft and 3.98% for eBay. Then move those over to columns H and I. In column J take the return minus the average which gives us 3.24%. That's 5.62% minus 2.38%. For eBay it is 8.91% minus 3.98%, or 4.93%. Carry that formula down for demeaned returns on each stock.
Next, in column L, multiply these together and follow through by adding the products, dividing by the number of observations to arrive at variance. Standard deviation is the square root of variance.
Again, in the second table, up to columns J and K, the calculations are the same. And because covariance and correlation refer to the co-movements between a pair of stocks, multiply them together this time. Follow through by adding the products, dividing by the number of observations to arrive at covariance. Then divide by the product of the two standard deviations to get correlation.
So, you can see the importance of demeaned returns. Once you have them you can quickly calculate four important risk measures.
Also, we used 6 periods here to keep it simple, but you can see how important the mean, in demeaned returns, is to the final calculations. This illustrates the importance of selecting a long enough period of say 30, 60 or more periods that you feel represent the data.
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