OB Report
November 2018
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The Truth about Averages

Steven Zicherman By Steven Zicherman CFA, Equity Analyst


Have you heard the one about the six-foot tall statistician who drowned crossing a river that was only three feet deep, on average? It’s an illuminating story because it highlights the limitation of simple averages.

In the investment business, forecasters often use historic averages to extrapolate trends and in doing so they often give their clients a false sense of security. The trajectories of the economy and the stock market are typically more variable than predicted.

The proverbial economic and stock market rivers run both fast and slow, and they have scary rapids and waterfalls too. Yet, the prognosticators rarely broadcast those realities. The Financial Crisis of 2008/09 provides a great example. The collapse of Lehman Brothers in September 2008 is commonly regarded as the height of the crisis, and as such, Wall Street recently marked the 10-year anniversary of that traumatic event. However, it is worth considering what forecasters were predicting a year earlier.

The Survey of Professional Forecasters, the oldest survey of economic forecasts in the United States, expected the economy to grow by 2.8% in 2008, on average. They were wrong. The Gross Domestic Product (GDP) actually declined 0.1% in 2008 and fell a further 2.5% in 2009. Recessions are typically not recognized until well after the fact. Indeed, the National Bureau of Economic Research, the nation’s business cycle arbiter, reported in November 2008 that a U.S. recession had begun in December 2007.

Investment analysts and strategists are not much better at predicting company earnings and stock returns, at least not in the short term. Some analysts go as far as making bear, base and bull case estimates, which may seem like a positive in terms of factoring in various potential outcomes. Nevertheless, the best and worst-case scenarios rarely capture actual earnings highs and lows. Why is it called a surprise when company earnings routinely vary from the estimates? Perhaps the real surprise occurs when earnings actually match the estimates.

When recent investment returns are low, investor sentiment and return expectations tend to be depressed; at this point, future returns are typically better than anticipated. The opposite is true at the other end of the spectrum. The investing crowd is usually most optimistic regarding prospective returns following a long period of rapidly rising stock prices and that sets the stage for disappointment. In our view, the surest way to achieve satisfying long-term investment results is to understand and manage our emotions. It is important to appreciate that markets are volatile and unpredictable in the short term. It is human nature to extrapolate trends and get carried away, particularly when market conditions veer toward the extremes.

We do not make official annual return predictions for the stock market, yet it is a question we are regularly asked by the media and our clients. When pressed, our answer has typically been 8-10%. One method used to forecast stock market returns is to look at the historical performance of a well-diversified stock index. This simple exercise reveals a return of 8-10% a year, on average. In reality, we have no idea what the market will do next year, nor do we expect to earn 10% each year we are invested. If only it were that easy!

Take a guess at the last time the S&P 500 Total Return Index generated a calendar year return of 8-10%. It was 1993. Annual stock returns are far more volatile than their historical average. In fact, the annual tally for U.S. stocks was negative 20% (or worse) only three times over the last 50 years. People tend to think of volatility as loss, but volatility is the measure of deviation from an average, and this divergence can be positive as well. U.S. stocks have gained 20% or more annually 17 times over the same period. Given this historical pattern of higher and more frequent positive outcomes, it pays to avoid making short-term forecasts and to stay invested over time. At the risk of repeating ourselves: it’s time in the market, not market timing that counts.

Research Chart

Having a long-term investment plan and sticking to it is easier said than done. Investors are only human and we are all ingrained with certain self-defeating, emotional tendencies. Managing those emotions is a critical part of successfully meeting our financial goals. Asking certain questions can help keep us on track. Are we overly confident or optimistic when markets are performing well? What risks are we ignoring when stocks are rising? Similarly, how do we behave when the market goes down and pessimism peaks? Do we run for safety after the damage is already done?

The ups and downs of individual stocks make it difficult for investors to stay the course. Take Amazon for example. Since its IPO in May 1997, Amazon has appreciated 130,000%, which equates to a 40% compounded annual rate of return. While that may seem like a slam dunk in hindsight, it was not so for the average investor. Along the way, Amazon shares declined by more than 40% on three separate occasions. Between November 1999 and September 2001, Amazon lost 93% of its value! It is probably safe to say that few investors had the guts and the conviction to hang on for the whole ride.

There is no easy solution to managing our behavioural tendencies, especially when Mr. Market goes manic. There is often a slew of bullish and bearish forecasters making the news. Resisting the urge to time the market during these inevitable highs and lows is difficult, but not impossible. Go for a walk, play with the kids or get some exercise. The businesses we own will be bigger, more profitable and more valuable down the road.

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