The Allure and Illusion of Averages: Understanding the Pitfalls of Averaging in Investment Performance
The thrill of investing has always been centered around the performance of investments for many investors. Witnessing the growth of one’s portfolio over time brings a sense of fulfillment. Observing the numbers climb, witnessing the increase in returns, and recognizing that one’s hard-earned money is actively generating more can be truly satisfying. However, grasping investment performance thoroughly is crucial. One common mistake that investors often make is solely focusing on the average return of investments. Let's delve deeper into the concept of average return in investments, its implications, the associated challenges, and the alternative approaches that investors can consider.
What is the average investment return?
In the world of investments, the term "average" pertains to the mean return yielded by an investment during a specific timeframe. This figure is derived by summing up all individual returns and subsequently dividing by the total number of periods, typically on a monthly or yearly basis. Such an analysis offers a snapshot of the investment's overall performance.
For instance, let's examine the table provided below. It illustrates three distinct scenarios where the average return on an initial investment of $1,000 is 0%.
| Scenario 1 | Scenario 2 | Scenario 3 | ||||
|---|---|---|---|---|---|---|
| Year | Annual Return | Investment | Annual Return | Investment | Annual Return | Investment |
| 0 | 1,000 | 1,000 | 1,000 | |||
| 1 | 10% | 1,100 | -20% | 800 | 20% | 1,200 |
| 2 | -10% | 990 | 20% | 960 | 20% | 1,440 |
| 3 | 10% | 1,089 | -20% | 768 | 20% | 1,728 |
| 4 | -10% | 980 | 20% | 922 | -20% | 1,382 |
| 5 | 10% | 1,078 | -20% | 737 | -20% | 1,106 |
| 6 | -10% | 970 | 20% | 885 | -20% | 885 |
| Average Return | 0% | 0% | 0% | |||
It's interesting to observe that despite all three scenarios showing an average return of 0%, the actual outcome for the investor was a loss. The real returns turned out to be -3% for scenario 1 and -12% for scenarios 2 and 3. With this issue with averages, let's delve into why many investors continue to rely on this method to assess investment performance.
The Allure of Averages
Simplicity
Averages are a commonly utilized tool due to their simplicity and ease of comprehension. By condensing extensive data into a single value, they help in understanding the overall trend or pattern in investment performance. This straightforward approach enables individuals, regardless of their mathematical proficiency, to make sense of intricate data sets.
Historical Context
When examining data, averages play a crucial role in providing context and aiding in decision-making. Investors often rely on past average returns to evaluate the current performance of stocks and determine their investment potential. By comparing present data with historical averages, valuable insights can be gleaned regarding trends in improvement, decline, or stability. This comparison is instrumental in guiding decision-making processes, strategic planning, and sometimes even future projections.
Nonetheless, the reliability of averages can be compromised if the dataset includes outliers - data points that significantly deviate from the norm. In the subsequent section, we will delve into the challenges associated with relying solely on averages for analysis.
The Problems with Averages
Averages fail to capture the intricate nuances of the market and the myriad factors that can impact an investment's success. This can create a misleading sense of confidence, as investors may lack a comprehensive grasp of the risks and potential returns linked to their investments.
“Averages fail to capture the intricate nuances of the market and the myriad factors that can impact an investment’s success.”
Overlooking Volatility
When it comes to investing, a key concern with using averages is the tendency to ignore the inherent volatility of investments. While high average returns may appear attractive, they can obscure substantial fluctuations in value. These fluctuations, known as volatility, have the potential to significantly affect an investor's returns, particularly if they need to liquidate their investment during a period of low returns. Thus, it is crucial to assess an investment's volatility in conjunction with its average returns to gain a more precise understanding of the associated risks and rewards.
Sequence of Returns Risk
The sequencing of returns plays a crucial role in shaping investment results, especially for individuals approaching retirement or already in it. A sudden drop in the market during the early stages of retirement can have a substantial impact on the sustainability of a retirement fund, a phenomenon commonly referred to as sequence of returns risk. Should a market downturn occur at the beginning of retirement, it has the potential to deplete a portfolio at a faster rate compared to the same downturn happening later in the retirement phase.
Time Frame is a Factor
Another concern that arises when utilizing averages is the timeframe employed in calculating the average outcome. Take, for example, the historical data on the S&P 500, a widely used benchmark for assessing U.S. stock market performance. Looking at the average annual return of the S&P 500 spanning from 1950 to 2020 shows an annualized return of approximately 11%. This figure may mislead investors into expecting an 11% annual return on their investments. However, if we shift the time frame to cover the years from 2000 to 2020, the average annual return decreases to around 7%. This represents a 36% drop from the 11% average return observed over the longer period. The discrepancy arises from the inclusion of the dot-com crash in the early 2000s and the financial crisis in 2008 within a shorter time frame. It is essential to carefully examine the timeframe utilized in presenting investment returns.
Ignoring the Power of Compounding
Finally, it's important to recognize that averages may not fully capture the impact of compounding on investments. Compounding, which involves reinvesting earnings to generate additional returns over time, plays a significant role in wealth accumulation. Unlike averages, which overlook this crucial factor, compounding allows for the exponential growth of investment returns. Investors should prioritize understanding the compounding effect in their investment strategy and consider it alongside average returns when assessing their investment choices.
Comprehending these issues related to averages is the initial stage in making well-informed choices utilizing performance data. In the upcoming section, we will examine alternative approaches for assessing investment performance.
Alternatives to Evaluating Investment Performance
Risk Adjusted Return
Risk-adjusted return is a technique utilized to assess the performance of an investment by considering the level of risk (volatility) involved in achieving a specific return. This method offers a more detailed view of investment performance, enabling investors to determine if the risk taken is in line with the returns obtained.
Let's re-examine the table above illustrating three scenarios. The table showcases three distinct investment scenarios, each presenting a unique pattern of annual returns. Despite all three scenarios having an average return of 0%, the risk associated with each investment differs.
In Scenario 1, there is a consistent sequence of alternating positive and negative returns. In contrast, Scenario 2 displays a more volatile pattern characterized by significant positive and negative returns. On the other hand, Scenario 3 exhibits a pattern of substantial positive returns followed by substantial negative returns.
By employing a risk-adjusted metric like the Sharpe ratio, we can compute the surplus return per unit of risk for each case. This enables us to assess the performance of the three investments in terms of risk adjustment, determining which one yields the highest risk-adjusted return.
In this instance, we derived the Sharpe ratio for each scenario. Scenario 1 exhibited a Sharpe ratio of -0.70, while Scenario 2 and Scenario 3 both showed a Sharpe ratio of -0.74. This suggests that, in terms of risk-adjusted returns, Scenario 1 has a slightly superior risk-adjusted profile.
Utilizing risk-adjusted return as an evaluation metric offers a valuable alternative to solely relying on average return. By considering the risk level associated with attaining a specific return, investors can enhance their comprehension of their investments, enabling them to make more informed decisions regarding portfolio management.
“ By considering the risk level associated with attaining a specific return, investors can enhance their comprehension of their investments, enabling them to make more informed decisions regarding portfolio management.”
Benchmarking
Benchmark comparison is an alternative method investors can utilize to assess investment performance. This strategy entails comparing the investment's performance usually to a suitable investable benchmark, like a market index or a peer group. Through this analysis, investors can determine if the investment is exceeding or lagging the benchmark, enabling them to make well-informed decisions regarding whether to retain or divest the investment.
For instance, an investor who owns a collection of US large-cap stocks can assess how well their portfolio is doing by comparing its performance to a benchmark like the S&P 500. If the portfolio consistently surpasses the index, it suggests that the investment is superior to simply investing in the passive index. Conversely, if the portfolio consistently lags behind the index, it may signal that the investor should reassess their investment and adjust their portfolio accordingly.
Benchmark comparison is a useful alternative method for evaluating the performance of an investment. By comparing the investment’s performance to a relevant benchmark, investors can gain a better understanding of how an investment is performing.
Dollar-Weighted Return
The dollar-weighted return, also referred to as the internal rate of return (IRR) serves as a valuable tool for assessing investment performance. By factoring in the timing and magnitude of cash flows like contributions and withdrawals, this method calculates the rate of return on an investment. This approach offers a more precise gauge of the investment's performance by capturing the investor's actual experience.
For example, let’s consider the table above again as an example. In each scenario, the average return is 0%, but the real return, which takes into account the actual investment values, is negative. In scenario 1, the real return is -3%, while in scenarios 2 and 3, the real return is -12%.
The dollar-weighted return is a useful alternative to using averages to evaluate investment performance. By taking into account the timing and size of cash flows, this method provides a more accurate measure of the investment’s performance, and can help investors make more informed decisions about how to manage their portfolios.
“By taking into account the timing and size of cash flows, this provides a more accurate measure of the investment’s performance”
These are just three alternative options that can be used to evaluate investment performance. There are many more options that you can use, each with varying levels of complexity.
Conclusion
Understanding the performance of investments requires a deeper analysis than just focusing on average returns. The constraints we discussed underscore the importance for investors to embrace a more sophisticated method(s) when assessing investment performance.
Alternatives such as risk-adjusted returns, benchmark comparisons, and dollar-weighted returns offer more comprehensive methods for assessing investment performance. This multifaceted approach enables a better assessment of investment performance, helping investors to make informed decisions.
Remember, the journey of investing is not just about watching numbers grow, but understanding the dynamics behind those numbers and making strategic decisions that align with one's financial objectives and risk tolerance.
If you want to learn more about investment performance assessment, check out my webinar "Assess Investment Performance Like a Pro".
