A person goes to City A, where the daytime temperature is 55 degrees and the night time temperature is 45 degrees. Another person goes to City B where the daytime high is 100 degrees and it drops to zero each night.
The average daily temperature of both cities is 50 degrees. If this is the only factor that our travellers consider when packing, someone is going to be in for an interesting trip…
Averages serve to give us a sense of a typical outcome over time, and they’re pretty simple to calculate. That’s why they’re widely used. The problem is that we don’t always know how the time frame chosen by the person calculating the average impacts the results. Nor do we know how much difference there is between the typical outcome and the actual outcomes used to calculate the average.
To illustrate, consider the following four investments and decide which you would prefer.
- 20%
- 11%
- ¾%
- -11%
Got your answer? Well, here’s the punch line: all four averages are the same investment (US stock market returns). Same investment, but calculated for different time periods throughout the last 20 years.
By the way, there hasn’t been a single year during that period when the actual market return for any year was equal to any of those four averages.
When statisticians work with a data set, one of the first things they do is calculate the average (which they refer to as the “mean”). But then they calculate a bunch of other things, too. That’s because they know that an average – as part of a set of measurements – may provide a useful insight; but stand alone it’s not worth as much, and it may even be misleading.
Publishers of financial data however, like to keep things simple. So they just stick with the averages. In so doing, they often convey a sense of market consistency which doesn’t actually line up with what actually took place. This sets the stage for investor expectations which are almost assured to not be met.
You may have experienced this if you’ve ever owned a mutual fund. Even though it was easy to look at Morning star or other sources for the fund’s average returns, your actual results were probably different.
You may have thought that something funny must have happened to your account while you held the investment and that you got an unusual result. In fact, practically everyone who invests in a given fund gets a return that’s different from the published averages, because few individual holding periods match the calculation period exactly.
The point: Don’t rely too heavily on averages when you are trying to determine what a normal return is for a given investment. It’s not a bad starting point (especially if you look at averages for several periods and they are all negative). But looking at averages alone doesn’t constitute a complete assessment. Averages obscure the details and variations that occur from one year to the next, and in many instances give a sense of return consistency that is simply not there.