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Too simplest … Too manageable?

By Lon Jeffries MBA CFP CMP®

Never forget the story of the six-foot tall man who drowned crossing the stream that was only five feet deep, on average.

We want to abide by averages because they make our lives simple and manageable. A couple on a date night assumes a movie will be an average of two hours long so they know when to schedule dinner with friends.

The entrepreneur wants to think in terms of making an average profit of $100,000 per year so he has a guideline regarding the standard of living he can enjoy.

The 65-year old retiree wants to assume he will live to the average age of 84.3 so he knows at what pace he can enjoy his nest egg.

Planning Gone Awry

However, when we rely too heavily on averages, our planning can go awry. If the movie runs longer than two hours, the couple will be late for their dinner date. If the entrepreneur has a slow year and earns less than $100,000, he may end up taking out short term debt to pay his bills. If the retiree lives past age 84.3, he may outlive his money.

Financial Planning Averages

The use of averages is essential in financial planning. A range of assumptions is required in the development of a financial plan – how long will you live, how much will you spend each year, what rate of return will your investments achieve, how much will you pay in taxes, what will the rate of inflation be, etc. Without these assumptions, retirement projections can’t be constructed. Further, the best method for making these assumptions is to use averages – an average life expectancy, an historical average rate of return, an historical average inflation rate, etc.

So, how do we prevent the use of averages from destroying us? The answer is by allowing enough time and repetitions for the law of averages to come into effect. Just because a basketball player shoots free throw shots at a 90% success rate doesn’t mean he will necessarily make the next free throw he takes. It does, however, mean that if he shoots 100 free throws he is likely to make 90 of them.

Beware Assumptions

A financial plan may assume you achieve an average annual rate of return of 7% per year. Of course, this doesn’t mean it is impossible that your portfolio will actually lose 10% over the next 12 months. It is critical to remember that the financial plan assumes you achieve a 7% return over the entirety of your retirement, which may be 30 years. Consequently, if a loss of 10% occurs in the first year of retirement, your portfolio still has another 29 years to achieve returns that average out to 7% per year. Thus, a 10% loss is far from catastrophic to your retirement projections.

In fact, the primary way a 10% loss could become catastrophic to your portfolio is if it motivates you to make changes to your investments that would prevent the law of averages from applying. If an investor sold their portfolio after suffering the 10% loss, it would essentially guarantee that the anticipated average rate of return won’t be achieved, and consequently, the financial plan would be likely to fail.

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For this reason, while it is true that over an extended period of time the stock market has averaged an annual return of 10%, we should always remember that there is a significant chance of the market taking a loss during any given year (or three-year) period, and it is possible that the market could endure a decade without any significant gains (similar to the 2000’s).

Still, if the financial plan requires an average investment return over an extended period of time such as a 30-year retirement, even these setbacks are far from certain to dislodge your secure retirement as long as time is granted for the average to work itself out.

Enter Howard Marks

As famed writer and investor Howard Marks said,

“We can’t live by the averages. We can’t say ‘well, I’m happy to survive, on average.’ We gotta survive on the bad days. If you’re a decision maker, you have to survive long enough for the correctness of your decision to become evident. You can’t count on it happening right away.”

Assessment

The use of averages has a purpose in financial planning, and in other aspects of life. We simply need to be confident that the figures we use for our averages are achievable over time, and allow time the opportunity to prove us right.

Pareto’s Law or Principle

The Pareto principle (also known as the 80–20 rule, the law of the vital few, and the principle of factor sparsity) states that, for many events, roughly 80% of the effects come from 20% of the causes Management consultant Joseph M. Juran suggested the principle and named it after Italian economist Vilfredo Pareto, who, while at the University of Lausanne in 1896, published his first paper “Cours d’économie politique.” Essentially, Pareto showed that approximately 80% of the land in Italy was owned by 20% of the population; Pareto developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas.

It is a common rule of thumb in business; e.g., “80% of your sales come from 20% of your clients.” Mathematically, the 80–20 rule is roughly followed by a power law distribution (also known as a Pareto distribution) for a particular set of parameters, and many natural phenomena have been shown empirically to exhibit such a distribution.^[2]

The Pareto principle is only tangentially related to Pareto efficiency. Pareto developed both concepts in the context of the distribution of income and wealth among the population.

More: 

• On The Next Stock Market Correction?
• Doctors Living With Higher Stock Market Volatility
• Are All-Time Stock Market Highs Really That Bad?

Conclusion

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• Dictionary of Health Economics and Finance
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Filed under: Financial Planning, Investing, Portfolio Management | Tagged: average investment returns, economic assumptions, Financial Planning, Investing, Lon Jeffries, pareto's law |