We hear it all the time. Somebody will say, “The average return in the stock market is XX%” or “The Super Equity mutual fund had an average return of XX%.” My first reaction to any comment using averages is skepticism.
Averages can be very misleading. For example, “cherry picking” a timeframe in order to show a high return is commonplace. On the other hand, the march of time itself can have a significant effect on averages. Consider your typical equity mutual fund prospectus. These all show a 10-year historical return. Now, consider a prospectus dated January 2018. The 10-year return would have included the roughly 34% negative return in 2008. However, that same prospectus updated at March 31st or June 30th would have eliminated the rapid market decline in the first half of 2008. The net result would be a significant increase in the 10-year return. Nothing else changed. Time marched forward and the “bad” numbers dropped off.
The biggest concern whenever an average number is used is whether it is a simple average or a compound average. If we’re talking about the stock market, a simple average would total the returns for each year and divide by the number of years. The compound average would reflect the actual ride a client would experience with that sequence of returns. Let’s take an example:
If the returns are exactly the same in each year, the simple and compound average would be the same. However, the market isn’t this consistent. Returns can fluctuate wildly. In a volatile market, negative returns have a disproportionate effect on the compound average. Let’s take a look at an example:
In this case, the simple average is still 5.00% but the volatility and negative return in the sequence create a compound average of 2.36%.
When explaining compound vs. simple averages to a client, I say something like this: “Let’s assume you are in an airplane flying from New York to Paris. You’re cruising along at 30,000 feet. Suddenly, the engines give out and you fall into the Atlantic. To an air traffic controller, your average altitude is 15,000 feet (30,000 + 0)/2. However, as a passenger, you are still under water.”
The bottom line is averages are misleading. When quoting an average, we are smoothing out all the fluctuations that make that average. Using averages incorrectly may be part of the reason typical investors do so poorly. The way our brains work, when we picture a 5.00% average, we are more likely to picture an upward sloping line rather than an EKG printout.
Psychologists refer to this as “anchoring.” The client hears an average of 5.00% and expects to get a consistent 5.00% every year. He anchors on that number and will be more likely to make a bad decision when returns vary from that anchor.
When we provide averages to a client, we should clearly explain the range of returns investors are likely to experience along that path. By doing so, we provide a correct set of anchors.