Beware of Averages
We use averages often in the business of investing and financial planning. We quote averages when we discuss a historical track record and when we make projections for the future. These are often a necessary part of our business. However, we need to understand how averages could skew investor perception and ultimately influence poor financial decisions.
Averages Mask Variability
Averages act as “anchors” to what we may expect in the future. Let’s say a financial plan determines that the recommended portfolio will average 7% per year and reach the investors goals. This is pretty common. What does that 7% look like? Since the brain thinks linearly, it is likely to take the shape of an upward sloping line. Since when does the market look like an upward sloping line? Never. Instead, the line is quite jagged – illustrating the variability of pricing in a stock market.
With the “anchoring and adjustment bias”, investors will often (unconsciously) anchor to a past return or a future expected return without any consideration for the price volatility they are likely to expect on the way to achieving the long-term expected return.
Advisors can do better; we must do better. With the understanding of how brains and biases work, we can “solve” this problem by providing more constructive “anchors” for the client. In addition to providing an expected long-term average return, we should also provide a range of returns the portfolio (or a security) may experience in the short term. This will greatly mitigate the influence of the anchoring bias and help your clients develop realistic expectations.
Averages Diminish Individual Consequences
Many financial professionals are familiar with the studies of how investors perform much worse, on average, than the index they are tracking. This is due to investor behavior (allowing emotions and mental shortcuts to influence decisions). DALBAR, Inc., Morningstar and JP Morgan are a few that have reported on these studies. While all the studies differ, it is generally accepted that due to poor investment choices, the average investor trails its index by over 3% per year.
But this average is nothing more than a compilation of investors who are disciplined in the investing and those whose choices cost them significantly. It is the latter group we are really interested in.
Their choices often result in performance significantly worse than an average of 3% per year. These are the people whose choices don’t just result in lower returns, but may never reach their goals. This happens often. People get scared, focus on short-term outcomes and make very costly decisions.
To the investors that sold earlier this year with all the talk of impending recession, they are down big. Some as much as 10% within a year. And now that they are in cash, when do they get back in? The reality is they may never get back in. So how much will that cost?
Averages can be very helpful in providing a “big picture” view. But when it comes to individual investors, we need to consider individual consequences. Our clients won’t experience the average. They will either experience worse than average (some much worse) or better than average. That is where the value of proactive behavioral coaching comes in. We know that emotions and mental shortcuts influence poor decision making. The question is how effective our systematic and proactive process is at helping investors make more deliberate, thoughtful decisions.