Rodney Johnson | Tuesday, May 14, 2013 >>
No, I’m not channeling the movie The Sixth Sense. I don’t see or hear dead people… but I do learn from them.
In this case, it’s regarding the oft-quoted statistic that life expectancy has increased by thirty years since 1900. Back then, people lived to the age of 48. Today they’re living to the ripe old age of 78.
That’s weird, don’t you think?
That figure implies that in 1900 there were no “old” people, or that old was anyone near 50. No gray haired people? No 70-year-old grandparents kicking around?
That doesn’t make sense.
So I checked into it…
Sure enough, the average age of death for a man in 1900 was 48. The average age of death for a man today is just over 78. That is indeed a 30-year difference.
If I look at the rate of death by age, the numbers get skewed.
Yes, the average age of death in 1900 was 48, BUT over 15% of the deaths occurred before the age of five. This enormous number of deaths before the age of five had the effect of dramatically lowering the average age of death in those days. For many of those who made it past five years old, they survived well into their 70s and 80s, which is much closer to what we’d expect, given our knowledge of relatives and people at the time.
Interestingly, we commonly attribute the extension of life to advances in health science that allow us to live into old age. The reality is that advances in health science stopped us from dying as children.
This is yet another example of misleading averages. When you dig just a little deeper it’s immediately obvious that the average age of death in 1900 is a pretty useless number. The same thing happens in the world of investing…
Since 1926, the average return on large cap stocks has been around 9%. That seems pretty good. I’d like a 9% return each year.
But of course the return is not 9% every year, it’s just the average. In fact, the returns are quite spread out. Technically speaking, the returns have a wide dispersion from the mean. So if the average return is 9%, but there’s a wide dispersion from this number, then how do we know what to expect each year?
Most, if not all, financial software uses normal distributions and standard deviations to calculate expected returns for investments. Without getting too complicated, the software assumes that the returns are normally distributed (like a bell curve), with a set standard deviation (or how far each year strays from the expectation of the average).
So the average return of large cap stocks may be 9%, but the standard deviation is 19%.
To be 99% sure that your estimate of next year’s return is correct, you must be willing to accept a range of returns. In this case, that range is three standard deviations above and below the average of 9%. You read that correctly. To be 99% sure – not 100%, mind you – that you have a good estimate of next year’s return on large cap stocks, you must be willing to accept a range of returns from 9% minus 57% (three standard deviations below) to 9% plus 57% (three standard deviations above). In other words, a range of negative 48% to positive 66%, or a 114% spread around the expectation of 9%!
What kind of planning is that?!
Who in their right mind would invest in something with the thought that it’s “okay” to have anywhere from a loss of almost 50% to a gain of more than 60% each year?
And yet that’s the exact way most financial software operates.
If you suddenly feel less sure about buying and holding equities, and have less faith in the statement that “over the long term, equities go up,” join the club!
There are better ways.
Instead of simply plodding along, buying and holding with the hope that it all works out in the end, be proactive! Take an active role in estimating the risk and reward potential of markets, industries, and individual securities. Look across the economic landscape at the different forces that are driving markets at the moment and ask yourself: “Does all this make sense?” If the answer is “No,” then you could be set to experience the low end of the expectation range for equities!
P.S. And consider these powerful 90-day kinetic trading cycles. They’re key to identifying the optimal time to buy and sell stocks. You can listen to this video. It gives you the details.
Ahead of the Curve with Adam O’Dell
The sequence of investment returns can impact lifestyles of long-term investors and retirees. It is equally important during shorter timeframes.