Why average return from investments is what you should expect and be happy with
Posted by: Uma Shashikant on Jan 01, 2018, 06.30 AM IST
If someone told us that we should be happy making average returns on our investments, it would probably be unacceptable to us. The lure of doing better or beating the average is something we simply cannot let go of.
The very notion of earning above average returns on a consistent basis is a statistical challenge. The average is derived from the tendency of returns to noisily wobble about, and refers to a line drawn to represent what should ideally be the central tendency.
Therefore, the actual returns our investments make will tend to be higher or lower than average most of the times. Those are random and noisy positions that cannot be attained by design. If we ended up with a return that is much higher than average and if we managed to stay there long enough, we might actually influence the average itself to move up.
Therefore, the idea of mean reversion in statistics is one that tells us that things tend to "average out" over time. However, we do not take the big picture view. When we look at the stock markets, for example, we look at the top performing stocks and set our sights on those numbers. When we make a decision to buy IPOs, we look at those that did very well on listing.
When we look at mutual funds, we look at funds that did very well in the recent past. We assign a much higher probability for these extreme, or higher than average events, to recur. There are at least two biases at play here. The first is the survivorship bias. Whenever we talk about performance, we look at businesses that have succeeded, and continue to exist. Those that did badly and failed are no longer around and we don't have their stock prices to look at.We systematically overstate the returns we might have made, because we have excluded failed firms from our samples.
Then there is the selection bias. We believe that there is a superior method that can be deployed to select the very best stocks, or funds, or IPOs, or portfolios and that such selection and the right timing can deliver an above average return. We feel quite confident that such a process exists and can deliver superior results. The risk in making these assumptions is in the very unpredictability of financial markets.
There are no rule-based systems that will deliver a fail-proof result, each and every time. There isn't even a method that will help us buy the superior stocks or funds, since what looks good today can turn bad tomorrow. If we agree that standing where we do today, if we bought a stock, there is a possibility that it would turn out to be a winner or loser, and that we cannot determine that outcome in advance, we will begin to respect the need to keep our expectations at the "average". We cannot select for tomorrow with the confidence that what we have will turn out to be an outperformer. This reality is tough to accept.
Conversations about returns focus on the winners. Those who manage to pick stocks that have been doing well speak about their success stories, much more than they would talk about failures. It would seem that selecting winners is easier than many would expect. There is enough aura around experts, trading strategies, algorithms, and such methods sold for the superior ability to generate better returns. It would be sacrilege to suggest that these returns could be an outcome of luck rather than skill. Fund managers tend to compare their performances with the median returns made by their peer group. This is a modified version of the average, taking into account the possibility that larger number of funds could be concentrated at the top and bottom of the league table. But the emphasis still is on the median or average returns, and funds wobble around this centre on a random basis.
There is also the argument that Indian markets are somehow different from the developed markets, and that earning higher returns is easier in our markets. This argument stems from the predominance of growth businesses in India, where several untapped opportunities enable firms to grow and expand exponentially. However, the risk that many of these firms also fail trying to chase those very opportunities, and the risk that an evolving market tends to offer more macro risks, is not usually discussed. For a hundred ideas that failed, the few that succeeded tend to hog the limelight, masquerading as if they were the norm.
Investors who made above average return are those who held stocks of the businesses they created; or held concentrated high conviction bets in a few stocks and businesses; or focused their attention on a few sectors. Think about each one of these strategies. They hold a high risk of failure just as they hold the possibility of success. For one Bill Gates who became the richest man in the world by holding the stocks of a single firm, there are thousands of technologyentrepreneurs who have gone bankrupt. We really do not know which one among the thousands of new entrepreneurs will turn out to be the next Bill Gates. To protect ourselves from these risks, we diversify. We hold stocks across sectors and firms, so we are cushioned from losses somewhat.
And the more we diversify, the more we tend towards the average. Realistically, safe strategies for the common investor tend to deliver returns that are closer to the average as a rule. We do not know which stock will do well, so we buy many to make a portfolio; we are not sure which mutual fund will do better than the others, so we choose a few different types; we do not know if the IPO we buy will list as a winner, so we buy a few allowing for a few hits and misses. As a habit thus, we average our returns. We tend to overstate things and believe in the extremes than in the average.
Ask around a group of your friends, if they think they are above or below average in looks, honesty, competence, earnings, empathy or any such thing you wish. You will be surprised how the answers lean so much on extreme values, and how very few see themselves as being just average. We brush aside the average since it connotes something ordinary in our minds. But the average is what things tend to with time, and long-term investment returns are not an exception.