When averages lie: Why investors need to recognize more than one possible outcome

When averages lie: Why investors need to recognize more than one possible outcome
Averages are not as harmless as they seem
When averages lie: Why investors need to recognize more than one possible outcome
Averages are not as harmless as they seem

 

Like the proverbial actuary with his feet in the oven and his head in the fridge (“on average, I’m just right”), it’s easy for investors to make too simple an assessment of the world. Often, it’s not the average that really matters, but the range of possible outcomes. Averages can sometimes disguise the most important facts.

Example #1: We are in a low return environment. Yet, somehow, global equity markets managed to rise more than 20%¹ last year. With interest rates still well below their average of the last fifty years, financial markets are offering less to investors than the historical norm. Indeed, with the real yield on five-year TIPS bouncing around near zero, we are still drifting in and out of a topsy-turvy world in which investors receive less than nothing for deferring consumption². But in the short term (strike that – make that the medium-to-long term) the impact of that low average expected return is swamped by the impact of market fluctuations. A low return environment does not mean we cannot see a 20% rise or fall in the next few months.

Example #2: And that means it’s misguided to take an expected long-term average and plug it into short term reporting, in the manner of corporate accounting’s Expected Long Term Rate of Return on Assets (ELTRA). The rest of the world has abandoned that approach and U.S. accounting for pension costs is overdue a change.

Example #3: Non-profit investors need to design spending programs based on a volatile asset return assumption, not a stable one. It’s reasonable to target a particular level of return—perhaps 5% above inflation—but a spending policy will only prove to be sustainable if it can cope with substantial fluctuations around the long term target.

Example #4: The average asset allocation of defined contribution plan participants is not a very useful measure. It is not unusual for one quarter or more of a plan’s participants to be either 0% or 100% allocated to equity. So who cares how the average did?

Nassim Nicholas Taleb become famous (and richer) by giving a name (the Black Swan) to the idea that sometimes it’s the low-probability extreme outcome that is the only outcome that really matters. He has a point. Looking only at averages can cause investors to take action based on what they think will happen, instead of on the range of possible outcomes. Why bother buying home insurance if there’s less than a 50% chance of making a claim? Why worry about the possibility of falling interest rates or falling equity markets (or falling house prices), if we expect them to rise? Beware of market commentary that tells us only what the forecaster thinks will happen: it can be the things that are possible, not just the things that are probable, that turn out to matter most.

¹ The Russell Global Index returned 24.4% in 2013. Source: Russell Investments.
² 5-Year Daily Treasury Real Yield on 5-year at 3/14/2014 was -0.19%. Source: U.S. Treasury.
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