Wouldn’t it be nice to live somewhere that has an average temperature of 75 degrees? Not too hot, not too cold, just right. Here’s the problem: Not everywhere with an average temperature of 75 degrees is desirable year round. Hawaii has an average temperature in the 70’s, with most months residing within the 60-80 degree range. Death Valley also has an average temperature in the 70’s, with the coldest months approaching freezing and the hottest rising to well over 100 degrees. What does this have to do with investing? More than you think.
Constructing a portfolio by making assumptions solely predicated upon average returns is a risky proposition. Much like the average temperature of Death Valley, average market returns rarely occur. Investors who expect the long term average return to transpire yearly will be disappointed more often than not.
Ed Easterling explains in his book Unexpected Returns:
“Averaging stock market returns over time masks the annual volatility of the market. An average number can lead to a feeling, perhaps even an expectation, of stable or consistent returns.”
So while average returns can give us a general idea of what the market will earn over time, we must keep in mind that this average number doesn’t reflect a yearly result.