Part 1 of the Market Myths and Misconceptions Series
“…the average depth of the river is only 3 feet so I can walk across it!”
- drowning statistician as he hits the part of the river that’s 10 feet deep.
“…the stock market goes up about 10%/year on average”
- nearly every Financial Advisor at their first meeting with a prospective client.
When I was deciding on whether to attend the University of North Dakota back in the mid 1990’s, I remember that in addition to researching their aviation and flight school programs, I thoroughly researched what the historical average temperatures were in North Dakota during the winter months. After attending school in Florida for a short time, this was a daunting move, but being that they had one of the most well-respected aviation programs in the country, it seemed worth the torture of heading north to freezing cold weather for a couple of years. I am not so sure that looking at the average temperatures did me any good in this case. Seeing that Grand Forks, ND had an average high temperature of 20 degrees during February was not pleasant, but nothing that an extra couple of layers and some heated socks couldn’t handle. What was even more unpleasant is that Grand Forks ended up having the coldest winter in recorded history while I was there. I experienced -39 degrees and if you want to factor in wind chill, it hit -65 degrees one lovely evening. This is something you should only experience on an expedition to Antarctica, but I was lucky enough for it to happen during my last semester of college. So much for that ‘average’ February temperature of 20 degrees.
I always liked working with averages in math class but I did not like it as much when it came to my Statistics class in college. Statistics taught me that averages were, well, not always as they seem. Start throwing in standard deviations, means, modes and medians…my grade point ‘average’ goes down. This is also true in the financial industry where averages are almost everything, especially when it comes to performance metrics and advertising. But are they really what they appear to be?
Let us take a hypothetical example of a mutual fund that shows the following annual returns over the past 3 years. Which one of these Funds would you be more likely to invest in?
Fund A: Year 1 Year 2 Year 3
86% -37% -19%
Fund B: Year 1 Year 2 Year 3
-15% 15% 30%
Each of these funds tells a different story but both of these funds would in fact show their annualized 3-year return for the period to be 8%. Does that mean you earned 8%/year? Not at all. In fact, if you started with $100k in Fund A at the beginning of the 3 year period, you would now have less than you started with! You would end the 3 year period with approx. $95k, a loss of 5%. In Fund B, you would end with approximately $127k, a gain of 27%. Two different funds with wildly different annual performance numbers but both reporting identical 3-year performance numbers. This is an example of how one outlier year can skew the entire performance metric. Average returns rarely happen in real life when it comes to your own money. They are much more common when it comes to financial marketing.
This takes us back to the very misused quote about stock market returns. The average return of the Dow Jones (DJIA) is often stated as 10%/year. This is a true number and is in fact a true 'average' over a very long period of time (approx. 100 years). But as shown in our example above, average return does not mean compounded return! It's a very misleading assumption and many financial plans are based on this flawed method of using these assumed ‘average' returns that are grossly elevated. I saw a proposal from another firm that simply forecasted making 9%/year for the next 20 years with a comment underneath the very large ending balance saying "Congratulations...you did it!!". Oh my...
I think back to the 1999-2000 timeframe that many of us can remember quite well…for better or worse. I recall the numerous people that were just entering the market during one of the most epic stock market manias in history. Many would take their 401k savings at retirement and go to a financial advisor who was anxious to get another hefty commission payout by selling some B-share mutual funds. The advisor starts showing the most recent returns from 1999…”The xyz Technology Fund is up nearly 100% this year and the average 3 year return is 48%/year!”. Many bought in. Others would decide to invest on their own since it seemed so easy to make money and those performance numbers being advertised are fantastic! Hey, if the E-Trade baby on TV could do it...so can I! Unfortunately, for those that decided to invest during this moment of time, they were in for quite an awakening. After the collapse of the Nasdaq, it would take 15 years to get back to even. "Pick Up The Pieces" by the Average White Band would have been an appropriate theme song for the time. But wait, they said the market averages 10%/year?
I recall the numerous Technology funds that were able to advertise their 1999 performance number for many years after the collapse since it boosted their ‘average’ annualized returns. One very popular Technology mutual fund at the time had the following annual return numbers:
1999 2000 2001
101% -34% -41%
The 3-year average annualized return reported by the Fund at the end of 2001 would have been shown as 8.7%/year. Did you make 8.7%/year? Well, if you had invested at the very beginning of the 1999 period, your return after 3 years, including doubling your money during the first year would have been -22%. Those darn averages...
The 100%+ returns that so many Tech funds had in 1999 looked spectacular, but in the end, it was only spectacular if you were invested in the fund ONLY during the year of 1999. Afterwards, it was more like being in Grand Forks, ND during the winter of 1996…
P.S. These 'Follies of Averages' were also implicit in one of the largest economic collapses in history in 2008 when the assumption that house prices always went up about 6% a year on 'average' caused many "experts" to be blindsided by the housing crash...but that's a story for another article perhaps!
- Eric