The Flaw of Averages is probably the most misunderstood concept in all of investing AND the most important concept to understand if you want to build a solid retirement plan.
The Flaw of Averages has everything to do with volatility. The concept of volatility is largely overlooked in investment planning because we’ve all been trained by the financial industry to ignore it.
Think about it – whenever volatility occurs in the financial markets, or more specifically, in your investment portfolio, you’re told not to worry about it because the markets always come back, right?
And if that doesn’t work, then you’re told there’s nothing you can do about volatility. It’s simply unavoidable. In order to grow your money, volatility is inevitable. But the truth is, excessive volatility can be mitigated.
Volatility is trained out of our thinking because we’re taught to focus instead on the average rate of return. This is precisely what I call “The Flaw of Averages.”
Think about the last time you allocated your 401(k) among the various investment options or the last time you researched investments of any kind. What did you do? I bet one of the main things you focused on was the historical rates of return… 1 year, 3 years, 5 years, 10 years, lifetime, etc. How do I know that? Because that’s what everyone does.
Unfortunately, my experience shows that this is absolutely the wrong approach to both building and evaluating your investment portfolio. Focusing on average rates of return, outside of the context of volatility, is meaningless.
Steven Covey says many people spend their lifetime climbing a ladder only to realize it was leaning against the wrong wall. Unfortunately, most people never realize their investment ladder is leaning against the wrong wall.
I’ve found the best way to teach this concept is with a few, simple mathematical examples. Now if you’re not a math geek like me, don’t worry, this is all very basic stuff. Trust me. It will make sense – and each one builds on the others.
Example #1 (+/- 50%)
Let’s assume you and your next door neighbor both have $100,000 invested for two years. Your neighbor earns nothing in her first year and nothing in her second year. Zero.
We can calculate her average rate of return by adding each of the annual returns together and then dividing by the total number of years.
So in this case, we add 0 + 0, which equals 0, divide by 2, which is the number of years we’re talking about, and we see the average return equals zero. No surprise here, right? (I told you it was simple math.) Her average rate of return over the two year period is 0%. And as you might expect, she still has her $100,000 after the two year period.
Now unlike your neighbor, let’s assume you lose 50% of your $100,000 during year one. You now have $50,000. Then in year two, let’s assume you earn 50%. But remember, you only earn 50% on the $50,000 you have remaining – not the full $100,000 you started with. So you only earn $25,000, for a total account balance of $75,000.
But when we calculate your average rate of return for the two year period, we get a surprise. Using the same method as we did before, we add -50% and +50%, which is 0, then divide by the same two years, and… woila! Your average rate of return is also 0%. Exactly the same as your neighbor! But unlike your neighbor, who’s investment is still worth $100,000, you now have just $75,000 – a whopping 25% less than you started with.
And in case you’re wondering, this isn’t just because you had a loss in the first year. If you run the numbers backwards – meaning you gain 50% in year one and lose 50% in year two, the outcome is the exact same. Go ahead, try it. The order doesn’t matter.
So here I’ve shown how two very different investments, both with an equal average rate of return over the same period of time, can have dramatically different results when measured in terms of actual dollars. This is why understanding the concept of volatility is so critical.
Let’s look at another example…
Example #2 (30/40)
In this scenario, let’s assume you lose -30% in year 1 and then gain 40% in year 2. This time, your average rate of return is 5%. Pretty good, right? But when you do the math, you’ll see your account is actually still down 2%!
So WHY does it work this way? It’s because losses hurt more than gains help.
Here we have three different hypothetical investments over a period of six years. One of them earns an average of 4% while the other two earn an average of 5%. The two that earn 5% produce dramatically different results from one another when compared in terms of actual dollars. So all 5%’s are not equal.
And even though a 5% average return is a full 25% greater than a 4% average return, the 4% average actually results in more dollars than the 5% with greater volatility. So you could get a whopping 25% higher rate of return than someone else, and still have less money in the end.
I want to share one last example to drive this point home – because as I said, I believe this is the single most important concept for you to understand if you really want to build a solid retirement.
In this example, imagine there are two accounts. The first is built to mitigate volatility. As a result, in good years, it only earns ½ of what the more aggressive portfolio does. But in bad years, it only loses ½ . So over time, it stands to reason that the average rate of return for the first portfolio is half that of the second portfolio. Yet as you can see, the first portfolio wins in terms of the actual account balance. And if you need to make a withdrawal at any time over this ten year period, you’d be much safer to do so from the first portfolio.
If this is your retirement account we’re talking about, volatility is much more important than rate of return. The question isn’t so much what was your rate of return, but rather how did you achieve that rate of return? Was it a fairly smooth ride, or was it more of a roller coaster? The answer is likely to make or break your retirement.
We have a saying – it’s not what you get, it’s how you get it. But the sad truth is all anyone ever talks about is rate of return, when in fact, the much bigger determining factor in your success is your ability to manage volatility.
This is the main focus when we build retirement plans because we want each person to understand precisely the impact managing volatility will have on their retirement success.