Is ‘average’ ever a good thing?
I often say that investing is not complicated but it is important to understand the basics so as to avoid some of the more obvious pitfalls and perhaps some misleading marketing from time to time.
With this in mind, we will first look at some of the important issues related to understanding average investment returns and introduce you to some important concepts and terminology.
We will then consider some of the more practical aspects of how this information is important when looking at your investments.
The average can be misleading…..
If I were to achieve a guaranteed average return of 10% each year it would look something like the blue line of asset A in Figure 1 below.
After 10 years my cumulative return would be almost 160% and, since it was guaranteed, I would have no deviation from this average each year. In other words, I would have absolute certainty of my returns and carry no risk to the outcome. This would be an average I would be thrilled with as an investor.
Unfortunately that is not how the real world works. Few assets deliver the same consistent return year after year. Even cash returns fluctuate according to prevailing interest rates.
The average return from an asset can mask the bumpy road an investor could travel over shorter time periods. Believe it or not, the green line in Figure 1 also represents a 10% average return but as we can see this average is comprised of alternating years of gains and losses to arrive at this number.
Figure 1: The 10-year return profile of two assets (A & B)
This graphic shows why it is never wise to consider average investment returns in isolation and why we need to look at returns in the context of some sort of risk measure.
Standard deviation is the most common measure of risk used in the investment industry. The standard deviation will give you some indication of how big the range of possible return outcomes can be around the average. The larger the standard deviation the greater the chance of achieving a return that is significantly different to the average we were expecting in any single year.
In Figure 1, as we have already stated, there is no dispersion of returns around the average 10% for asset A, and so the standard deviation is 0%. But with asset B, it is clear that the returns do deviate around the average, and in this case the standard deviation of asset B is actually 17%. This means that the returns from asset B could be 17% either side of the 10% average in any given year (That is returns range between -7% and +27%).
It is not hard to choose which of the two risk-return profiles any sane investor would opt for given the choice.
The average can lie……
Consider Figure 2 where you invest R100 in a portfolio of assets. After a year you have lost 50% but the following year you gain 100%, giving you a simple average return of 25%. That sounds pretty attractive on the face of it but it is quite clear that the actual return you have achieved is 0%.
Figure 2: If you invested with the following return profile
The example in Figure 2 illustrates the important distinction between using the simple or arithmetic average return versus the geometric average when considering investment returns.
The difference between the two results is that the arithmetic measurement assumes the two years are independent of each other.
(-50%+100%) = 50% divided by 2 = 25% (Arithmetic Return)
The geometric return on the other hand accounts for the fact that the two years are in fact dependent on each other:
Year 1: We start the year with R100 and lose half or 50% over the course of the year.
Year 2: We start the year with only R50 and, even though we double our money with a 100% gain over the year, we are only back to our original R100 value and have in reality made a 0% return overall (Geometric Return).
Note that the standard deviation in Figure 2 is also a high 75%, which should alert investors to the fact that the returns they are achieving come with a significant level of risk.
Practical implications to consider based on the above discussion on average returns:
i. An average return is unlikely to be representative of what you will experience in reality. Returns in any single year can deviate significantly from the average. Your investment strategy may be based on an average return of 12.5%, if you invest only in equities over the next ten 10 years, but during that period you may see an annual gain in the market of 40% one year and a fall in the market of -30% in another year.
ii. Despite the shortcomings of average returns, they remain useful when assessing a reasonable expected return profile and asset allocation strategy in the financial planning process. However, when comparing assets or funds you must be sure to use the geometric average returns and make sure you do so in the context of that asset or funds risk (standard deviation).
iii. Different asset classes display different risk-return profiles. Shares or equities will typically deliver average returns in excess of bonds and cash over the long-term but shares will also display a higher standard deviation. The success of your long-term financial plan will rely on you achieving a certain average return over the life of your strategy and your portfolio must be constructed of assets that will deliver those returns. This may mean you have to accept a higher risk or deviation of returns over shorter periods to achieve your objective.
iv. By being aware of the potential range of returns you may experience from any particular asset class, rather than just the average, you can avoid some of the more common mistakes investors repeatedly make. Don’t be caught out by the promise of a 10% average return (with a 26% standard deviation)and then sell your investments during a year where the market sells off by 30% or more because your strategy is failing. These sorts of moves are entirely possible and even expected and selling could be a sure way to suffer a permanent loss of capital.
v. You always need to make back a higher percentage gain versus the percentage value of what you lost just to break even. A 50% loss requires a 100% gain to recover back to your starting point. This is because your portfolio value after a loss is always smaller than what your portfolio value was before the loss.
vi. A commonly touted piece of investment advice is NOT to try and time markets. This is true of trying to trade your long-term portfolio for short-term market fluctuations but you should be sensitive to committing new lump-sum (large once-off payments) investments following periods of strong market gains, particularly in equity markets. Despite an asset class offering a healthy long-term average return, you can suffer very heavy losses over the short-term, which can dent your enthusiasm for investing.
vii. Retirement plans will usually carry large exposures to shares or equities. Retirement funds are long term investments and shares typically deliver the best long term average returns, so you want exposure to this asset class to maximise the value of your retirement savings. But retirement plans will usually reduce exposure to equities the closer you get to retirement – life cycle planning. This is because equities can suffer large falls over short time periods and may take some time to recover. You want to minimise the chance of loss of capital the closer to retirement you get, so you reduce exposure to the assets that could potentially do this.
These concepts are all fairly easy to understand and most are common sense. Unfortunately all too frequently when faced with sharp declines in the value of our funds, we tend to lose the ability to apply common sense and to think rationally. By having a strategy that you are confident in and that you understand, you are far more likely to successfully manage your expectations and your emotions when the inevitable downturn in the cycle comes around.
Please contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.