The problem with averages

My wife and I were college sweethearts.  We both graduated from the University of North Carolina in 1980, married less than a year later and are now in the process of living happily ever after.

Tammy majored in zoology, the pre-cursor to her first career as a registered nurse.  My degree was in journalism.  She was out to cure the world while I was out saving it.

I felt lucky to land a job in my chosen profession, even if it paid just $190 per week, before taxes.  If you’re any good at history, you’ll recall that the ‘80s began with a severe economic recession.  And if you’re any good at math you’ll know that my $190 weekly salary worked out to less than $10,000 a year.

So imagine our surprise years later when we learned that the average annual income of geography majors from our alma mater during that decade was said to be well over $100,000!¹ Now, the geography program at UNC is first-rate but tiny.  I’ll bet you could fit the entire graduating class into an airport shuttle bus.  How did these folks become so financially successful right from the start?  Geography?

Turns out that one of those geographers was named Michael Jordan.  Yeah, that Michael Jordan.

Are therein lies the problem with statistics.  Technically truthful, they often mislead us in what they seem to represent.  Take investment returns for example.  Between 1926 and 2019, the S&P 500 has delivered an average annual return of 10.2%.  But the actual year-to-year returns hardly ever came close to that number.  The S&P 500’s actual returns fell between 8% and 12% in only 6 of those 94 years!²

The mistake investors often make is confusing average returns with actual returns.  Using an extreme hypothetical example, if your portfolio loses 50% this year and earns 50% next year, your average return is exactly 0%, despite the fact that you’ve actually lost 25% of your money over the two years.

Losses are more impactful than their equivalent gains; that’s how statistics work.  A 50% loss requires a 100% gain to fully recover.  A 75% loss takes a 300% gain to break even, and it only gets worse from there. 

That little piece of wisdom can come in handy when it comes to designing an investment portfolio, especially if you’re planning to withdraw money from that portfolio to cover your living expenses in retirement.  Big losses in a single year can take several years of above-average investment performance to get you back on track.

Thankfully, there are ways to lower that risk.  Diversifying your portfolio among different types of investments can help.  Another method is to keep a portion of your portfolio in more stable investment vehicles and systematically withdrawing from those reserves to cover your spending needs.  This approach can help minimize the need to sell growth-oriented investments, such as equities, at unfavorable prices.

Remember, when it comes to making money last for a lifetime, you need better than “average”.  You might be well over six feet tall like Michael Jordan.  But if you’re trying to wade across a river without knowing how to swim, it doesn’t help to know that the average depth is only four feet.

¹ The Minitab Blog, March 9, 2012

² Feast or Famine (amgfunds.com)

Any opinions are those of The Mike Brown Financial Group and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. The S&P 500 is an unmanaged index of 500 widely-held stocks that is generally considered representative of the U.S. stock market. Inclusion of these indexes is for illustrative purposes only. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Diversification and asset allocation do not ensure a profit or protect against a loss.