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Why “average is not normal” — and why most people get this wrong

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Tons of people have withdrawn all their money from the stock market because….well, they don’t really know why — it just feels “bad” to keep it in.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:

Period 1:

1995: 37.6%
1996: 23.0%
1997: 33.4%
1998: 28.6%
1999: 21.0%

Period 2:

2000: -9.1%
2001: -11.9%
2002: -22.1%
2003: 28.7%
2004: 10.9%

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).

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  1. I seem to be one of the few excited about the stock market. I have maxed out my IRA and am contributing more now than ever to my 401(k) because it’s on sale! When it goes up, as it will and I am young, I will be glad I kept on buying!

  2. Ramit,

    First, define long-term.

    Second, read this: “Do shares really always rise?”

    Third, stop talking about stocks – nobody really knows where the market will go, and that includes you. You may have saved a lot of people some money with your little negotiation and credit card tips, but you’re so far out of your league on market issues that you may be reversing all the good you’ve done in other areas.

    You are being irresponsible and foolish. Plus you’re showing your age.

  3. Ramit – Just quickly, your link to GRS appears to be incorrect.

  4. I was waiting for that choppy chart to zoom out so you could see how insignificant those peaks and valleys are over the long term.

    That’s why I like to use charts as examples, especially the MAX time frame. That’s when all the “small stuff” gets smoothed out and you realize that what happened 20–30 years ago on a year-to-year basis doesn’t really matter.

  5. Great post. All those ups and downs all even out to an average return IN THE END, but not specifically in a certain year.

  6. Hi Ramit – I totally agree with what you are saying about taking a long term view and not worrying about short-term changes in the market. I also agree that this *may* be a great opportunity to take advantage of a huge sale and buy buy buy (and I am). But as someone who studied statistics, modern portfolio theory and just read The Black Swan, I’m a bit worried about the future. I think people who are feeling like they want to take all their money out of the market should carefully remember what they are feeling right now (write it down!), and use that to properly adjust their risk tolerance looking forward. If the tolerance (and therefore asset allocation) you’ve chosen depends on “hoping” for some sequence of returns, there is a big problem, and you are in for unhappiness.

  7. I think a few people have looked at the difference in long-term results from investing at a high point vs a low point and found that it’s pretty small. Of course investing is a process and not a single point in time (unless you just received a very large amount of money), so the time when you start may only have a direct impact on a few hundred or thousand dollars.

    Hopefully anyone who just sold their business is acting the same way as someone who just retired after saving for 40 years, and not putting it all into stocks unless they have another source of income over the next 10 years. Then it’s just the usual story; those who are selling want the prices to go up (and when they sell it pushes the prices down) and those who are buying want the prices to go down (and when they buy it pushes the prices up). And those who just want to live off the dividends don’t care what happens to the price.

    Then again most people who are buying want the prices to go up so they can feel good about themselves now instead of later. Even when that makes the rest of their lives harder.

  8. Best piece of advice in this post: “Focus on the long term! I’ll kill you!”

    My husband and I are getting our Roth IRAs started this year now that we’ve paid off consumer debt and auto loans. It is a little scary, but I remind myself that we are not retiring anytime soon, and that not investing anything, ever is scarier!

  9. Ramit,

    I, like you and most of your readers, am relatively young (31). I usually agree with you completely, and I support the analysis that average is not “normal.” However, I think it is risky to simply prescribe the typical long-term buy-and-hold strategy.

    This is the strategy peddled by financial advisors – the same people who would have us conflate “average” and “normal.” The statement “if you are young, then don’t worry about your retirement funds. Buy and hold” has been true our entire lives, since the early 1980s. However, that model may be changing.

    If you look at the average inflation-adjusted returns over a very-long period, our lifetimes have coincided with a major boom ( The swings come in 15 to 20 year periods. This is not a normal recession that we are in; this is the beginning of a fundamental restructuring across all levels of the global economy.

    I cannot say what will happen in the future. I can say, however, that there is a risk that the new model that we will be living with, potentially into our 50s, will be very different from the one that we grew up with. Even if stocks are prices near the long-term trend line today, they have a long way to go over-correcting below. Staying out of the market for a few more years could reserve more capital that could be used to buy at even lower prices in 5 years.

    I don’t advise anyone to time the market at a micro-level, but at the meta-level, we have more pain to come. “Buy and Hold” is what you hear from people shilling financial products. Our generation will need to be more fundamentally flexible in our thinking and not robotic.

    All that being said, the safe thing to do, if someone is a completely inactive investor, is to set your contribution rate and just let it keep buying on the way down. It might not be the BEST deal, but as long as you are young enough it will be a GOOD deal. And everyone should always contribute enough to get the max employer match out of a 401(k), because that’s just claiming your maximum compensation.

    It’s just very frustrating, if you are a somewhat active investor, to put in $100 and then see it shrink to $75 over and over for years on end before it fundamentally turns around. The story is similar to the one I heard about dollar-cost-averaging down. A man made an investment in Bear Stearns last year at the height, convinced it was a strong company. As everything happened, he continues to buy more to lower his average share price as it fell, convinced that the government or the economy would save the company and he’d one day make it all back. He did this down to a price of $1 per share. We all know how that ended…

    This is what can happen if you blindly follow typical financial advice in atypical times.

  10. […] human behavior influences investment returns at Behavior Gap. If you liked this article, check out the companion piece at I Will Teach You to Be Rich (one of my favorite personal-finance […]