Flaw of Averages
Probably the most common
investment mistake is to rely on
averages in assumptions about your
future and investing. The trouble
begins when we take a current
portfolio and plug in a long-term
rate of return. It is a widespread
method that relies on average
returns. This flaw continues to
disrupt investment planning today as
it has for decades. Betting on
averages in like the statistician who
drowned while fording a river that
was, on average, only three feet
deep as the cartoon to the right illustrates.
Let’s review the concept of average performance in the stock market. Over the last seventy-five
years, the average stock return has been about 11 percent annually. Similarly, the average
intermediate bond total return has been about 6 percent annually. The danger occurs when you
use average returns from individual securities or broad market indices in a planning program.
In reality, equity returns including the market indexes, vary substantially from year to year. The
return is rarely average! For example, the annual market return as measured by well-known
market measures, such as the S&P 500 Index, have been as much as 50 percent above average or
25 percent below average on any given year. When a person is withdrawing money to live on,
things look very good when the markets are going up 30 percent. On the other hand, things
become very disheartening when they plummet 20 percent in a year. Thus, it’s easy to see that
relying on “the flaw of averages” for planning can be financially disastrous. However, it’s often
the method used by many advisors.
A better approach is to base your planning decisions on absolute returns, which are those real
returns that occur year after year. That way you can determine volatility and look at current
trends before betting the farm that you’ll come out close to the average.
Let’s look at how averages confuse the issue. Until recently, all financial planning models gave
an answer based on a fixed set of variables that used some average return. The outcome can be
very misleading, as you’ll soon see. Both of the
number sets to the right have an average return of
10%. The first, unrealistic model used average
returns and produced $259,374 while the second
produced only $163,823, more like what investors
have faced over the last decade. Such a disparity
could have a significant outcome on a person’s
standard of living. And if you think these numbers
are exaggerated, just look at the performance of
the Nasdaq Composite over the past decade and
you’ll see that they are “spot on.”
Begin Rtn End
$100,000 -39% $61,000
$61,000 -31% $42,090
$42,090 -21% $33,251
$33,251 0% $33,251
$33,251 20% $39,901
$39,901 25% $49,877
$49,877 49% $74,316
$74,316 67% $124,108
$124,108 20% $148,930
$148,930 10% $163,823
Average 10%
Absolute Returns
Begin Rtn End
$100,000 10% $110,000
$110,000 10% $121,000
$121,000 10% $133,100
$133,100 10% $146,410
$146,410 10% $161,051
$161,051 10% $177,156
$177,156 10% $194,872
$194,872 10% $214,359
$214,359 10% $235,795
$235,795 10% $259,374
Average 10%
Average Returns
But how can this be? As assets are reduced due to market declines, we have less money to apply
the positive returns to. Therefore, the portfolio must work harder just to make up lost ground and
often requires monstrous returns to break even or get ahead.
The solution is twofold. We must to do a better job managing the
downside risk of our portfolios and base our planning on absolute numbers
to help gauge the likelihood that our investment will produce the result we
anticipate. In this scenario, we’d have actually been off better earning just
6% (absolute). While significantly less than the 10% return projected
above, it actually produced $179,085, a much better outcome as you can
clearly see from the last number set. That’s pretty amazing; earn 40% less
return but wind up with more money!
David Wismer
March 2006
Begin Rtn End
$100,000 6% $106,000
$106,000 6% $112,360
$112,360 6% $119,102
$119,102 6% $126,248
$126,248 6% $133,823
$133,823 6% $141,852
$141,852 6% $150,363
$150,363 6% $159,385
$159,385 6% $168,948
$168,948 6% $179,085
Average 6%
