Cutting Edge Insights
with Dr. Lee

The Illusion of Average

Mediocrity isn’t all it’s cracked up to be

“Average” can function both as a noun and an adjective.  As an adjective, some of its meanings include:

equaling an arithmetic mean;

being about midway between extremes;

common; not out of the ordinary

(Merriam-Webster)

Or, from an old friend of mine who sadly passed away in 2019:

“Average is the best of the worst and the worst of the best.”

It seems as if we humans typically strive to be above average and view the same as desirable; at the same time, we acquiesce to, accept, or take comfort in average when it comes to things beyond our control:

  1. The weather – We’re OK with average highs/lows/precipitation.
  2. Investment Returns – Certainly, we would like above average returns, but we typically don’t expect them.
  3. Customer Service – Being accustomed to average is precisely why we’re taken aback when service is exceptionally good or especially terrible.
  4. Our children – well, our kids are an extension of ourselves so we usually want them to be above average in school, sports, etc.  But average is better than below average.

As you can see, “average” definitely has connotations in a qualitative sense, but it also has a numerical definition: an arithmetic mean.

You’ve heard, I’m sure, the logic error that follows the use of average when the term median would be more appropriate:

By way of example,

Consider:  The average home sale price is $500,000.

Reality:  The median home sale price is $350,000 – there were a couple outliers that skewed the mean higher.  Most likely, if you have an average home (see what I did there), you’d be closer to the median, not the mean.

However, lesser known is the erroneous way that mutual fund companies present their investment returns.

They manipulate basic mathematical operations to make their returns look better.

The crux of the error is that they speak in terms of “average returns”, as in, first computing the actual return for each year in question, then averaging those actual numbers to arrive at an average return “per year”.

Example:  Macrotrends.com, as well as many other websites, chronicles the historical returns of major equity indices.  For example, the S&P 500 is up some years and down others.  It might go up 10% then down 19% then up 5% then down 20%.

If you invested $100 in the S&P 500 in 1991 and followed the course of that $100 through the ups and downs of 30 years, you would have $1,137 at the end of 2020.  (That $1,137 in 2020 dollars would only be worth $592.00 in 1991 dollars, but that’s a different story – see our articles on inflation here and here).

But if you add all the ups and downs of the individual years, then divide by 30 years, you get an “average” yearly return of 9.87%.

This does not correctly articulate what happened to your money over that time period.  

But this is how mutual fund companies advertise to you!

If it did correctly articulate the 30 years of gains, then $100 x (1.0987) ^ 30 would equal $1,137.

But it doesn’t.  

$100 x (1.0987) ^ 30 = $1,684.

$1,684 DOES NOT EQUAL $1,137.

They are trying to tell you that you would have had $1,684 after 30 years but you would have only had $1,137.

What can we conclude from this exercise in middle school mathematics?  Mutual fund companies use “average” returns to spice up the appearance of doing business with them.  They all do it – I checked the websites of Schwab, Vanguard, and others – they all throw the term “average annual” in front of returns.

In the case of the S&P 500 between 1991 and 2020, average return would have overstated actual return by 48%.

And that isn’t an error I’d want to see in my investment portfolio. It’s a logic error, not any other type.

Just as the complacency of accepting “average” in life may prevent you from experiencing greatness, believing the illusion of “average” in your returns may hide reality.

As you think about that, be aware of marketing efforts to brainwash you.  Study the numbers – they’re not that difficult to understand, and the raw data won’t lie.

Until next time,

Dr. Lee Newton

What real estate investing, building science, or development questions do you have?  I’ll be happy to answer them here.  Send them to Lee@CEassets.com.

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References:

https://www.merriam-webster.com/dictionary/average
https://www.macrotrends.net/2526/sp-500-historical-annual-returns
https://www.inflationtool.com/us-dollar?amount=100&year1=1991&year2=2020

 

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