Why “average is not normal” — and why most people get this wrong
February 11th, 2009 - 47 Comments
Tons of people have withdrawn all their money from the stock market because….well, they don’t really know why — it just feels “bad” to keep it in. Logically, we all understand that the stock market’s average return of about 8% is an average — meaning it goes up and down — but when our 401(k) drops 40%, we want to get out immediately. (More about investor psychology.)
When Carl Richards from Behavior Gap, showed me his slideshow below, I loved it. Now, he’s written up a companion guide to illustrate exactly how this applies to you.
Notice the key points that Carl makes below:
- The stock market’s precipitous drop is catastrophic for anyone who needs to retire on their money now. (Technically, they should have a dramatically reduced exposure to stocks, but most people don’t know what asset allocation is, let alone practice regular rebalancing.)
- However, if you’re young, the drop in stock prices is a huge advantage to your long-term growth.
- Too many people make gut-wrenchingly bad decisions because of fear and the irrational belief that they can predict the near-term moves of the stock market. In the short term, anything can happen. By having a longer time horizon, you can mitigate risk and almost certainly predict considerable investment returns. BUT YOU CAN’T TIME THE MARKET, ESPECIALLY IN THE SHORT TERM. FOCUS ON THE LONG TERM!!! I’LL KILL YOU!!! (This is Ramit talking, not Carl)
Ok, on with the presentation.
Since “Average is Not Normal” launched, I have had a lot of very engaging conversations and I want to share some of the insights from those conversations.
To provide some context lets start with the tale of two periods. Below are the annual returns of the S&P 500:
A few thoughts:
1-Imagine if you sold your business in late 1994 and planned on investing the money and living off your investments for the rest of your life. Because of the timing of the sale you start with a huge tail wind. In this case, having a series of way “above average” returns earlier is a huge benefit
2-What if you sold in late ‘99, and your first few years were way “below average.” On top of the market being down dramatically, you are selling to fund your lifestyle. This double whammy can result in a death spiral. On top of the market being down, you have to continue to sell to fund your lifestyle. As this cycle continues, you are taking a larger and larger percentage of your portfolio each year. It only takes a few below average years for this to become a problem.
3-Despite dramatically different results in term of dollars, 20 years later these two time periods could have close to the same 20 year average rate of return.
4-If you are just starting to fund your 401(k), you should hope for the opposite sequence of returns versus your friend who just sold his business. It can be depressing to see your account go down month after month, but for the person still actively saving, you would hope to have “below average” returns early when you don’t have a lot of money at risk.
5-When you are in the accumulation stage, it would be great for the market to be down or at least flat so you can buy more shares “on sale.”
6-There is no such thing as a “good” pattern of returns. What was “bad” for the person who sold his business would be “good” for the person in the early years of funding his 401(k).
7-We have no idea what the sequence of returns is going to be for the next five years.
8-Investing is risky. You could chose an investment that does “great” over a twenty year period, but due to the timing of the above average and below average returns, you could end up broke.
9-Because every person has unique savings and withdrawal goals, real financial planning can not be done as a one-size-fits-all solution.
10-Understanding that average is not normal should result in the realization that real financial planning is a process of setting a course and then making the small course corrections as we deal with the random nature of returns.
If you liked this article, check out the companion piece at Get Rich Slowly (one of my favorite personal-finance blogs).
One of my students asked this amazing question, and I loved it so much that I want to share it ...Read More