Monday, April 20, 2015
Living and Dying on Averages
Never forget the six-foot tall man who drowned crossing the stream that was five feet deep, on average.
We want to abide by averages because they make our lives simple and manageable. A couple on a date night assumes a movie will be an average of two hours long so they know when to schedule dinner with friends. The entrepreneur wants to think in terms of making an average profit of $100,000 per year so he has a guideline regarding the standard of living he can enjoy. The 65-year old retiree wants to assume he will live to the average age of 84.3 so he knows at what pace he can enjoy his nest egg.
However, when we rely too heavily on averages, our planning can go awry. If the movie runs longer than two hours, the couple will be late for their dinner date. If the entrepreneur has a slow year and earns less than $100,000, he may end up taking out short term debt to pay his bills. If the retiree lives past age 84.3, he may outlive his money.
The use of averages is essential in financial planning. A range of assumptions is required in the development of a financial plan – how long will you live, how much will you spend each year, what rate of return will your investments achieve, what tax rate will you pay, what will the rate of inflation be, etc. Without these assumptions, retirement projections can’t be constructed. Further, the best method for making these assumptions is to use averages – an average life expectancy, an historical average rate of return, an historical average inflation rate, etc.
So how do we prevent the use of averages from destroying us? By allowing enough time and repetitions for the law of averages to come into effect. Just because a basketball player shoots free throw shots at a 90% success rate doesn’t mean he will necessarily make the next free throw shot he takes. It does, however, mean that if he shoots 100 free throws he is likely to make 90 of them.
A financial plan may assume you achieve an average annual rate of return of 7% per year. Of course, this doesn’t mean it is impossible that your portfolio will actually lose 10% over the next 12 months. It is critical to remember that the financial plan assumes you achieve a 7% return over the entirety of your retirement, which may be 30 years. Consequently, if a loss of 10% occurs in the first year of retirement, your portfolio still has another 29 years to achieve returns that average out to 7% per year. Thus, a 10% loss is far from catastrophic to your retirement projections.
In fact, the primary way a 10% loss could become catastrophic to your portfolio is if it motivated you to make changes to your investments that would prevent the law of averages from applying. If an investor sold their portfolio after suffering the 10% loss, it would essentially guarantee that the anticipated average rate of return won’t be achieved, and consequently, the financial plan would be likely to fail.
For this reason, while it is true that over an extended period of time the market has averaged an annual return of 10%, we should always remember that there is a significant chance of the market taking a loss during any given year (or three-year) period, and it is possible that the market could endure a decade without any significant gains (similar to the 2000’s). Still, if the financial plan requires an average investment return over an extended period of time such as a 30-year retirement, even these setbacks are far from certain to dislodge your secure retirement as long as time is granted for the average to work itself out.
As famed writer and investor Howard Marks said, “We can’t live by the averages. We can’t say ‘well, I’m happy to survive, on average.’ We gotta survive on the bad days. If you’re a decision maker, you have to survive long enough for the correctness of your decision to become evident. You can’t count on it happening right away.” The use of averages has a purpose in financial planning, and in other aspects of life. We simply need to be confident that the figures we use for our averages are achievable over time, and allow time the opportunity to prove us right.