Loads of people love the average or the mean as statisticians call it. However, the mean can misguide you terribly as a measure of value.
One day when attending a budget meeting in Texas (post UNICEF) there was this newly minted MBA who was talking about measures and seemed to stress too much on the average. Then I interjected and asked how good the average would be if one’s head is in the refrigerator and the other in the oven. Of course, there was laughter from the audience, and the young man said he could not answer me.
The mean can really be mean when you take the average gains of a stock or mutual fund over a term of years. Say, that one particular stock or fund has gained on average 10% over 10 years. Now you got to know what type of average has been applied: a price-weighted arithmetic average, a value-weighted average or a geometric average. Whatever method is used the mean can still be mean.
No wonder, the old saying holds true that the devil is in the details.
Assume you just heard that some precious metals stock has an average gain of 25% over 10 years and are fascinated with that performance. Therefore, you want to buy it even at a high price in the hope that it will do well for the next 5-10 years. However, when you look at the details, year by year, we may be in for a big surprise.
Suppose the 10-year individual year gains are as follows:
Year 1= 2.0%; Year 2 = 2.0%; Year 3 = 5.0%; Year 4 = 1.0%; Year 5 = 5.0%; Year 6 = 6.0%; Year 7 = 1.0%; Year 8 = 1.0%; Year 9 = 25.0%; Year 10 = 202.0%.
The 10-year average = 25.0%.
Remember when gold prices were flat for many years!
Therefore, when you are looking at average prices it pays to look at the details that make up that average. An investment like the above would certainly not be a good buy either in years 9 or 10.
When looking at averages it is more meaningful to take the average and the standard deviation. In the example given, the average is 25% but the standard deviation is 59.4%. What use is an average that has a standard deviation that is 2.4 times larger than the average? I think I made my point. This is not rocket science, but many ordinary investors make fatal mistakes with averages.
However, there are other problems with the mean on which I will make a passing statement only as it can get too complicated to cite numerical examples. Consider this statement: The American stock market was overvalued in the late 1990's to 2000 with the dot-com bubble. If one takes an average of that period investor gains were driven by a windfall or a period when stock prices were over-valued to the hilt and thus made great annual investor gains (that is if they were lucky to realize it). What I am saying is that good statisticians would smooth out the numbers to adjust for the unusual periods. Suppose it rains for five days at one inch per day and on the 5th day it rains 10 inches, say the highest in 50 years. So the second case is that it is also good to know the environment behind the numbers.
Let us face it. There will be no mean if there was no historical data. That is why stock analysts say that the past is no guarantee for the future. However, they also strongly believe that everything in life reverts to the mean. Almost everything in social life focuses on the normal distribution (the bell curve) and ignore the outliers as they are too difficult to deal with. Outliers can cause havoc. When the stock market crashed in October 1987, some people committed and almost committed suicide. In fact one broker jumped out of an office window. And one day prior to that, no one said it was going to happen. Even when the stock market crashed in early 2000, some analysts were yet bragging how it will climb higher a few days before that.
The mean can take other meanings. You walk into a meeting room of 30 people and take the average intelligence of the discussion. Given freedom though, it is one brilliant individual who may may make a great contribution and bring the meeting to a early close and a great success. Now outliers can be positive or negative. One could say that prior to September 2001, on average we were safe. But one single incident, an outlier, changed the entire course of events for America. Although the WTC towers came down, New York has recovered, and we are back to the mean again. However, since the WTC towers came down I am not free to walk in freely to an UNICEF Office housed in a private building.
The lesson we learn my friends is that without historical data there is no mean, and it is very hard to predict the future. On average, I was going out each day for three days a week on my bicycle and always returned safe. However, on June 28, 2005, one dreadful outlier and I had a serious bicycle accident. Now I have reverted to the mean, but who expected an outlier to be in waiting. As far as investing is concerned then, you have to be diversified across industries, and stocks and bonds so that the means of means will give you some immunity of total loss. If I bicycle 200 yards, walk 200 yards and swim 200 yards, I will reach 600 yards more safely that doing only one event. But, it is difficult to find such an ideal state of life. However, you can do it with your investments but yet stand the risk that the mean can let your down miserably. Diversification, which I call the mean of means would of course give you some immunity. But I think we had the advice since many years ago, not from the stock analyst or taxicab driver - when Grandma said: "Do not put all your eggs into one basket."
Note: For further knowledge in the area of personal finance please refer to similar articles in the Personal Finance Index at 2Merrill . Disclaimer: References to Personal Finance are strictly for "educational purposes" and does not hint or offer any specific financial advice. For financial advice, please seek the advice of a professional if you feel unable to handle your own finances.
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