Probably the most common investment mistake is to rely on averages in assumptions about your future and investing. The trouble begins when we take a current portfolio and plug in a long-term rate of return. It is a widespread method that relies on average returns. This flaw continues to disrupt investment planning today as it has for decades. Betting on averages is like the statistician who drowned while fording a river that was, on average, only three feet deep.

Let’s review the concept of average performance in the stock market. Over the last seventy-five years, the average stock return has been about 11 percent annually as measured by the S&P 500 index. Similarly, the average intermediate bond total return has been about 6 percent annually. The danger occurs when you use average returns from individual securities or broad market indices in a planning program.

In reality, equity returns, including the market indexes, vary substantially from year to year. The return is rarely average! For example, the annual market return as measured by well-known market measures, such as the S&P 500 Index, has been as much as 50 percent above average or 25 percent below average on any given year. When a person is withdrawing money to live on, things look very good when the markets are going up 30 percent. On the other hand, things become very disheartening when they plummet 20 percent in a year. Thus, it’s easy to see that relying on “the flaw of averages” for planning can be financially disastrous. However, it’s often the method used by many advisors.

A better approach is to base your planning decisions on absolute returns, which are those real returns that occur year after year. That way, you can determine volatility and look at current trends before betting the farm that you’ll come out close to the average. 

Let’s look at how averages confuse the issue. Until recently, all financial planning models gave an answer based on a fixed set of variables that used some average return. The outcome can be very misleading, as you’ll soon see. Both of the number sets below have an average return of 10%. The unrealistic model to the left used average returns and produced $259,374, while the model to the right produced only $163,823, more like what investors have faced over the last decade. Such a disparity could have a significant outcome on a person’s standard of living. If you think these numbers are exaggerated, just look at the performance of the Nasdaq Composite over the past decade and you’ll see that they are “spot on.” 

Average Returns                                        Absolute Returns

Begin            Return     End                         Begin            Return        End
$100,000     10%        $110,000                 $100,000      -39%         $61,000 
$110,000     10%        $121,000                 $61,000        -31%         $42,090
$121,000     10%        $133,100                 $42,090        -21%         $33,251
$133,100     10%        $146,410                 $33,251           0%         $33,251
$146,410     10%        $161,051                 $33,251         20%         $39,901
$161,051     10%        $177,156                 $39,901         25%         $49,877
$177,156     10%        $194,872                 $49,877         49%         $74,316
$194,872     10%        $214,359                 $74,316         67%         $124,108
$214,359     10%        $235,795                 $124,108       20%         $148,930 
$235,795     10%        $259,374               $148,930       10%         $163,823
Average       10%                                        Average         10%

But how can this be? As assets are reduced due to market declines, we have less money to apply the positive returns to. Therefore, the portfolio must work harder just to make up lost ground and often requires monstrous returns to break even or get ahead.

The solution is twofold. We must to do a better job of managing the downside risk of our portfolios and base our planning on absolute numbers to help gauge the likelihood that our investment will produce the result we anticipate. As illustrated in the scenario below, we’d have actually been better off earning a simple 6% in the safety of something not correlated to the stock market. While significantly less than the 10% average return projected above, it actually produced $179,085, a much better outcome as you can clearly see when compared to the number set to the right above. That’s pretty amazing – earn 40% less return but wind up with more money! It’s all about assessing returns properly.

A Better Solution

Begin            Return             End
$100,000        6%               $106,000
$106,000        6%               $112,360
$112,360        6%               $119,102
$119,102        6%               $126,248
$126,248        6%               $133,823
$133,823        6%               $141,852
$141,852        6%               $150,363
$150,363        6%               $159,385
$159,385        6%               $168,948
$168,948        6%               $179,085
Average          6%