Investing 101: Average is NOT Normal

On average, stock market returns are higher than inflation, money markets, or bonds. Understanding this is an important step to any successful financial plan, but there is a huge difference between “average annual” and “every year”.

Many of the commonly-used approaches to financial planning take long-term average rates of return and then make the assumption that you will get that return every year. Say you build an investment portfolio that you think will have an average return of 8.5%. Just because the average is 8.5%, it should be obvious to anyone that has been alive the last 12 months that this does not mean we will get 8.5% every year.

While this may seem obvious, the implications are huge.

 

Let's walk through two hypothetical examples. In both scenarios that follow assume:

  1. They start with the same amount of money.
  2. They add the same amount each month.
  3. Both investments have the same average rate of return.

Scenario One: Bad Years First
You start with a small initial investment and then do the right thing by adding money each month. You feel like you are throwing good money after bad because each month your statement arrives and it is lower. But you continue to accumulate shares of the investment. After years of “bad” performance you have built up a sizable portfolio and the market turns, and you have years of “above” average returns. In this case the “good” returns came at the time when you had the most money to benefit from them.

Scenario Two: Good Years First
On the other hand, you could spend years adding to your portfolio every month and be very excited because the investments you have chosen perform really well right from the start. You have a bunch of “above average” returns for the early years when you don't have a lot of money at risk. Then as you get more money “at risk” you have the normal cycle, and your investment is down for a few years. Here the “bad” returns came at the time when you had the most money at risk.

So both investments have the same rate of return, but the investor in scenario one ended up with more money.

Your investment return is only one part of the equation in a financial plan. (The other part is your life.) Because average is not normal, it is important to view financial planning as an ongoing process, and not a one-time event that assumes that we will receive that “average” rate of return.

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Beth - Smart Family Tips
Beth - Smart Family Tips
11 years ago

Excellent explanation of this concept. I admit that I am mathematically challenged to some degree and this example easily clarified what could be a confusing concept for some — or at least one that we don’t necessarily think about often.

JerichoHill
JerichoHill
11 years ago

I *love* seeing psychology enter into the financial discussions.

Average also isn’t normal as most people are “risk-averse” in the economic sense…we don’t like losing money, a loss is more painful than an equivalent gain is pleasurable.

Thus, our own psychology causes us to have the urge to buy high and sell low.

I think that by being aware of our own tendencies and how they help/hurt us, makes us more able to close the behavior gap

Writer's Coin
Writer's Coin
11 years ago

I saw this over on Ramit’s site (IWillTeachYoutobeRich), and I’ll repeat what I said there: I kept waiting for that slide with the choppy gains to zoom out to show how insignificant those ups and downs were in the long run. But I guess zooming and those kinds of things is kind of advanced for a slide show like this…

GoForexYourself
GoForexYourself
11 years ago

Loved the video, a great way to introduce the market.

There are two different kind of traders, the active (per minute trader) and the conservative trader(per hour,days,etc). I always found it to be more beneficial to be a conservative trader, in the long-term, the market tends to always bounce back to it’s profitable state.

Miranda
Miranda
11 years ago

It is important to identify what kind of trader you are, and then look at your tendencies.

I also liked the illustration of buying during the bad years. We are upping our retirement account contributions and other areas of our portfolio, looking for fundamentally sound companies that are great bargains right now. Some of our friends think we’re crazy for not liquidating everything right now, but I’m hoping in the long run we’ll be scenario #1.

Dave
Dave
11 years ago

This is exactly why I started investing in an RRSP now, while I’m only 23. The small amount I put in now will be worth millions once this recession clears up.

Centsability to Wealth
Centsability to Wealth
11 years ago

Interesting article.

It seems this would not apply to those investing in the stock market long-term, though.

If you are consistantly putting money into the market for 20, 30 or 40 years, you will see every kind market several different times, and it should even itself out.

Obviously the key is to avoid hitting the large downturn in your last five or ten years, which should be prevented by proper asset allocation the closer you get to using the money.

Strabo
Strabo
11 years ago

Thank you very much! The misuse of normal vs. average in terms of return is always something that bugs me a lot. Great article!

Associate Money
Associate Money
11 years ago

My investment approach is to buy and hold.

Though it has been despairing to see my portfolio shrinking about 35%, I am averaging down my investments.

Hopefully when the market swings up, I will be able to achieve above-average returns too.

Peter Owen
Peter Owen
11 years ago

This is an excellent post to put things in perspective. From what I usually hear, as long as you leave your money in the stock market, it will grow like the line in the slide show. Seeing the actual numbers helped open my eyes.

According to your examples, now would be the time to invest and I agree.. though invest in what?

the weakonomist
the weakonomist
11 years ago

Behavior Gap is popping up everywhere these days. I like this idea of average not being normal. Like in any statistic, rarely is someone actually average. I like to look at the medians as much as the average, and bell curves are like statistics porn.

Good post.

Dylan
Dylan
11 years ago

Carl, very well put, and the slide show is top notch!

Jeff
Jeff
11 years ago

Three Words:
Dollar Cost Averaging

RobertD
RobertD
11 years ago

I am 50 I have yet to ever meet an average person. Averages like an index are only of value for comparing past performance. They may even serve to suggest future performance, but if you can not rely on them to do that. If you want any chance of growing your investment you have to do your homework. Learn everything you can about how they achieved heir past performance and then see how they want to earn future returns. If both appear solid then you should consider investing in them. There is no way around you doing your homework if… Read more »

J.D.
J.D.
11 years ago

Just a reminder: I really believe that Carl’s post works best when read along with my article on how much the stock market actually returns. Both pieces look at different aspects of the same phenomenon. Together, they provide a more complete picture of investment returns.

Chris
Chris
11 years ago

@ Dave: Pretty optimistic, buddy. I invested “a small amount” in the S&P since 1999 and AM STILL underwater. Banking on small amounts turning into millions is pretty rosy.

@ the slideshow: Wow… That quite possibly dumbed down that topic to the greatest degree possible. I suppose it’s easier to explain it that way rather than defining what a standard deviation is.

tinyhands
tinyhands
11 years ago

Please don’t lose sight of the first statement in this article, and remember that you do not have to beat the stock market; You only have to beat inflation. As long as you’re saving at the rate required to meet your goal, you only have to avoid losing money. If you are not (or cannot) save at the rate required to meet your goal, you must either save more or alter your goal. (If you invest your savings and do better, great, just don’t count on it.) In order to do this, you must first have a goal and then… Read more »

Chris
Chris
11 years ago

@ Tinyhands –

“Thus, there’s nothing wrong with average.”

That’s what she said, that’s what she said! 🙂

Steve@hundredgoals.com
11 years ago

Good post. In our current economic situation I think it is important for people realize the opportunity they might be missing out on by discontinuing retirement contributions. I know many people who have seen their savings plummet and decide to stop investing until the market comes back. The idea of buy low and sell high is hard to do when you are emotionally battered by watching your money leak away every day.

For me, things are on sale, time to buy!

Finally Frugal
Finally Frugal
11 years ago

Thanks for this post, which makes me feel more comfortable (and less foolish) for recently increasing my contributions to my 403b account to 15% of my salary, rather than running far, far away from any investment in the stock market whatsoever. I’m hopeful that my willingness to put money into my retirement plan at the exact time when the market is doing so very poorly will result in higher returns when the economy improves, as it surely will. I have a good 20 years until retirement anyway, meaning that I can afford to ride out this current recession.

almost there
almost there
11 years ago

Well, I feel like a chump. Since ’84 I have invested the maximum amount into IRAs. (with some exceptions for some years) Always in growth mutual funds managed by big houses (dryfus, Vanguard, American Century). Through last week my 61K invested (not counting dividends reinvested) and what I have now, just dividing return by 25 years = 1.7%/year, so, less with dividends added to the calculation. My spouse started later,(also almost maxing out her contributions) but her return on investment in her IRAs after 20 years = 2.7%/year, so less with dividends added to her calculation. I decided to leave… Read more »

Matt @ StupidCents
Matt @ StupidCents
11 years ago

Problem is, it’s impossible to time the market. Dollar cost averaging is your friend, and down markets shouldn’t scare you away from the market.

My strategy is to allocate more money to my funds that are doing the worst. I usually evaluate every 3 months.

So far it’s been working out great, but my portfolio wasn’t immune to the past 12 months.

Stupidly Yours,

Matt

Ken
Ken
11 years ago

I agree with other posters about the power of dollar cost averaging. Investing a little each month saves you from steep moves of the market and allows you to continue to buy in methodically.

Ben
Ben
11 years ago

This recession is different than anything the US orthe global economy has ever seen. I have a sneaking suspicion all these people planting money in the stock market now because of the “bargain” prices are in for a big surprise. The spending of the stimuli packages is unprecendented and will lead to a decade of inflation. The crisis we are facing is global, not national. The stock market is adjusting itself to ACTUAL value instead of market value which was grosly inflated for the last 6-7 years. No one know what the future holds, but my one word of advice… Read more »

Ben
Ben
11 years ago

Just another quick comment. J.D. I’m surprised with all that’s going on in Washington, that you haven’t had a post on your perspective on the stimulus. I know it could be a controversial subject but this is important and extremely relevant. Not to mention I think you would get a record number of comments.

J.D.
J.D.
11 years ago

@Ben
I’ve written about the economy several times in the past, but I don’t like to dwell on it. It’s something outside my control. Sure, it affects the decisions I make, but only peripherally. For the most part, I stick to my plan.

I do have a few thoughts that I may try to craft into a post for this afternoon or tomorrow, but they’re not directly related to the stimulus packages.

I think the best move in a situation like this is to special attention to your own personal economy.

Carl Richards
Carl Richards
11 years ago

@Chris- thanks for the feedback, yeah the goal was to take a concept like standard deviation and look at it from a different perspective.

Carl Richards
Carl Richards
11 years ago

@Matt- reviewing your investments once a quarter (or year) and shifting “more money to the funds that are doing the worst” is a great way to unemotionally buy low (relative to your other holdings). You are “forcing” yourself to add more money to the investments that statistically have the highest chance of outperforming. Over course, this should always be done in small tweaks over time. Great comment!

Carl Richards
Carl Richards
11 years ago

Just a note of clarification: this was meant to highlight a concept in general terms. The application of the concept is going to vary dramatically based on YOUR personal situation.

It is not a plug mindlessly “buy and hold”. It is a plea to take the massive amount of variability into account when you are creating and updating you financial plan.

Thanks to everyone for the feedback! It is great to see this conversation taking place!

Carl Richards
Carl Richards
11 years ago

@JD, Ben: I love the concept of focusing on your own “personal economy”. It is amazing the power that unfolds when we focus in what we control, now.

Neil
Neil
11 years ago

Great article, it highlights the importance of contributing to your investments on a regular basis during both the good and the bad times.

al
al
11 years ago

i am 23 and just invested in a Roth IRA and 401k last year when i got my first job out of college. they have lost a lot, of course, and it’s soooo hard to think about investing any more in them in the very near future. i try hard not to think about my admittedly small losses, but it’s definitely been a painful lesson for this first-timer. thanks for this post, it was kind of a pep talk for me!

Chett
Chett
11 years ago

JD,

Good post on the reality of returns. MSN has a story up right now on their front page blasting Suzie Orman and her principles of dollar cost averaging and many other mantras she used to speak to the public about personal finance. http://articles.moneycentral.msn.com/RetirementandWills/CreateaPlan/stop-listening-to-suze-orman.aspx?page=1

Felipe
Felipe
11 years ago

I like this article, but it’d be really great if its title was ‘Average is NOT the usual’. Normal has mathematical connotations and, in some cases average can be normal (http://en.wikipedia.org/wiki/Normal_distribution) but still very unusual.

J.D.
J.D.
11 years ago

@Chett Ugh. James Scurlock. He’s a smart guy, and he does some good work, but he seems to pathologically avoid the notion of personal responsibility. He’s all about how the Big Bad World makes it impossible for the Average Person to succeed. To be blunt, I think this is bullshit. I’m not a huge Suze Orman fan (I think she’s fine, but not stellar), but find Scurlock’s article fatuous. Orman has most of her $32 million in bonds? So what? The choices you make with $32 million are different than the choices you make with $32,000. When you have $32,000,… Read more »

Adam
Adam
11 years ago

All of this assumes that your investment market continually grows in the long run. While we have seen this trend in America so far, our sample size is pretty tiny.

Naysayer
Naysayer
11 years ago

I can’t help feeling slightly uncomfortable with this whole “OMG U R ID10T if you aren’t maxxing out your 401k and keeping your money in risky stocks even if your portfolio is badly wounded and leaking more blood every day” mentality. It is too general and big brotherish. It also gives people who are retiring in <5-7 yrs the totally wrong advice, neglects mentioning that having some liquid savings is always a superb idea, scoffs unnecessarily at safer funds, and doesn’t touch on it being the best for the Economy, but not necessarily the best for You. It makes me… Read more »

Chett
Chett
11 years ago

I agree this was a hack, and was suprised to see MSN put this on their front page. I think Orman is a little flakey (I hate the approved or denied section of her shows) but many people have improved their financial position because she got them to thinking about personal finance. I think so many “professionals” are quick to fire judgement on Orman, Ramsey, and other pop culture personal finance people out there. The problem has been for so many years that unless you had dollars to invest, advisors weren’t willing to spend time with you. Now that there… Read more »

J.D.
J.D.
11 years ago

Naysayer wrote: I can’t help feeling slightly uncomfortable with this whole “OMG U R ID10T if you aren’t maxxing out your 401k and keeping your money in risky stocks even if your portfolio is badly wounded and leaking more blood every day” mentality. Well, I hope that nobody in a responsible position is saying that. And I hope that you’re not seeing advice like that at GRS. The important thing is to understand your goals and the best tools to reach them. For many people, that’s by investing in stocks (either directly or through mutual funds) in a tax-advantaged retirement… Read more »

Felipe
Felipe
11 years ago

The professor John Allen Paulos gives an example of an investment in which the average means nothing for the investor. I don’t remenber the title of the book but the story was like this: “A high-risk fund invests in new companies. 50% of the companies are good investments and a week later they can take the principal and a 60% profit. 50% of the companies are bad investments and a week later they only can recover 60% of the principal” And the question: is it a good investment? The answer is yes: 0.5·1.6+0.5·0.6=1.1, it means a 10% profit per week.… Read more »

Carl Richards
Carl Richards
11 years ago

@Naysayer: thanks for pointing that out. You are right on. This post should not be seen as another stump speech for everyone to just grit their teeth and hold on regardless of age or peace of mind. This conversation really is about THINKING about a concept that can have a massive impact on your planning but is rarely talked about. There is good reason to consider carefully your exposure to stocks. Do you need to have money in the stock market (at any age) to meet your long term financial goals? No. If you can’t stand the thought watching you… Read more »

Dividends4Life
Dividends4Life
11 years ago

This post’s title reminded me of one on my all time favorite quotes:

“The people who want to achieve and aspire to be very good in their profession don’t mind the way we do things. It’s not normal to want to be as good as you can be. It’s normal to be average.”
— Nick Saban, Head Football Coach, University of Alabama

Best Wishes,
D4L

chacha1
chacha1
11 years ago

All I wanna say is, for people whose retirement is not imminent, please look at your 401(k) statements again, breathe deeply, and focus on the bottom line where it says “Unrealized Loss”. That means the loss isn’t real unless you sell the stock at the stated price. So if you sell when your stock is at its lowest, yes, you have lost money. But if you can calm down and leave it alone long enough, historically the trend is for individual stocks and the market as a whole to rise, and in time the investment should recover some or all… Read more »

Aleks
Aleks
11 years ago

The second example is basically what happened to me. I started investing in 1999, right before the dot com crash. Now we have the global financial meltdown. Unfortunately I didn’t track my contributions over the years, but based on napkin calculations I haven’t earned much of anything over the past decade. Which is why those oversimplified examples of compounding annoy me. “If one person invests $2000 a year for 8 years and then stops, and another person waits 8 years and then invests $2000 a year for the next 40, they will end up with the same amount of money”… Read more »

Largebill
Largebill
11 years ago

Timing the market is about dumb luck. Dollar cost averaging tends to work. However, it works much better for some rather than others based on the dumb luck of when they start investing. Someone in their 20’s today who invests regularly for the next 20+ years will do great eventually with equity funds. If you started in the 90’s you’d have been buying in the peak and now holding through a possibly protracted valley.

Our politicians are trying to replicate what FDR did to turn a recession into a depression so there may be a long opportunity to buy low.

Steph
Steph
11 years ago

Rainfall: average is not typical in this subject, either, at least in California.

We could probably come up with a pretty big list of abnormal “averages.”

My Journey To Billionaire Club
My Journey To Billionaire Club
11 years ago

Amazing……….
Mind blowing…………..

Excellent article……….. Amazing hypothesis……..

I will add both of these hypothesis in my blog also….. (of course after putting a link of this post on the top….)…

thx for such a nice guest post JD….

Tres
Tres
9 years ago

Hmmm. No one’s going to read this comment, but I thought I’d weigh in.

If your initial years are good enough, the compounding interest early on will offset the losses later. Compounding is a powerful force. In particular, if the money’s in a traditional IRA, the lack of taxes applied to annual gains will tend to increase the effectiveness of compounding interest.

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