The Edmond Sun

Business

May 31, 2013

THE ASTUTE INVESTOR: Fun with statistics can make your head spin

EDMOND — Mark Twain is often credited with the famous line, “There are three kinds of lies: lies, damned lies, and statistics.” It is a phrase describing the persuasive power of numbers, particularly the use of statistics to bolster weak arguments.

You can learn a lot from dead people. No, I don’t talk to them. But I do learn a lot from statistics about them. As an example, an often quoted statistic says that life expectancy in the U.S. has increased by 30 years since 1900.  We hear that people lived, on average, to the age of 48, while today they’re living to the ripe old age of 78.

Think about that for a moment. That implies that back in 1900 there were no “old” people.  That doesn’t make sense so I did a little research. Sure enough, the average age of death for a man in 1900 was 48 and today it is just over 78 — a 30-year difference. However, if you look at the rate of death by age, the numbers look quite different.

Yes, the average age of death in 1900 was 48, but more than 15 percent of the deaths occurred before the age of 5. This enormous number of deaths before the age of 5 had the effect of dramatically lowering the average age of death in those days. For many of those who made it past 5 years old, they survived well into their 70s and 80s.

Interestingly, we commonly attribute the extension of life to advances in health science that allow us to live into old age.  While some of that is true, the far bigger reason was advances in health science stopped many of us from dying as children.

This is another example of misleading averages. When you dig just a little deeper it’s 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 percent. That seems pretty good. I’d like a 9 percent return each year. Wouldn’t you?

But, of course, the return is not 9 percent 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 percent, but there’s a wide dispersion from this number, then how do we know what to expect each year? Good question. I’m glad you asked.

Have you ever gone online and used one of those free financial planning programs to calculate what your investments might do in the future? Be careful. 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). The average return of large cap stocks may be 9 percent, but the standard deviation is 19 percent. Now that’s a different animal.

If you want to be 99 percent 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 (three times 19) above and below the average of 9 percent. To be 99 percent sure — not 100 percent, 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 percent minus 57 percent (three standard deviations below) to 9 percent plus 57 percent (three standard deviations above). In other words, you could see a range of negative 48 percent to positive 66 percent, or a 114 percent spread around the expectation of 9 percent!

How do you feel now? What type of financial planning is that? Who in their right mind would invest in something with the thought that it’s “OK” to have anywhere from a loss of almost 50 percent to a gain of more than 60 percent each year? That’s crazy! 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! This suggests a rather dim future for traditional asset allocation strategies.

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 unless you know what you’re doing, you could be set to experience the low end of the expectation range for equities. Thanks for reading.

NICK MASSEY is a financial adviser and owner of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.

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