Averages are used all the time in finance, usually to justify performance (‘above average’). However, as an investor, you should realise there are several ways to calculate an average.
The three most common are the mean, median and mode. Let’s say you have five FTSE 100 readings on consecutive days. They are 4,800, 4,900, 4,700, 4,800 and 5,100. The mean is the sum of the five readings divided by the number of readings, so (4,800+4,900+4,700+4,800+5,100) divided by five. That’s 4,860. One of the problems is that extreme outliers can give a misleadingly high or low figure.
The median is the reading in the middle when all the data are ranked in ascending order. So looking at our figures, that’s 4,800. You can use the median to test the mean – if the two are close together, the mean can be taken as representative and not unduly distorted by outliers.
Finally, there’s the mode – the most common reading. In this example, that’s also 4,800.