Another thought-provoking article by Ernie McDaniel
“Lies, damned lies, and statistics” is a comment on the abuse of statistics I have over the years heard attributed to Disraeli, Twain and even Truman, but no matter how many people may have said it, or of what great fame and authority, or how often, it is no more true -- and no less. Truth is not democratic. Truth just is. In our blessedly democratic American culture, however, folks tend to believe that which they hear most and in the most places. And they do truly hear certain statistics repeatedly, including stock market return statistics, for example. Can these statistics be, as the quote suggests, the worst of lies?
Well, let’s begin by saying that statistics of any kind can never be more than a half-truth. After all, their very purpose is to distill the complicated into easily understood and communicated information. The whole truth is often a meaningless and unwieldy array of dates and numbers. So, whether we like it or not, the use of statistics is necessary. Unfortunately, few people understand them well enough to judge whether the statistical information they are being given serves to expose the truth or to twist it. This is no less the case for financial statistics.
Averages are a simple kind of statistic, and average returns are commonly used in the financial world. Let me illustrate with an example how even these can be misunderstood. [This is a purely hypothetical example and does not reflect any particular financial vehicle.]
Suppose you were to place a sum of money in some financial vehicle and earn a 100% return the first year. On this same money, you then suffer a 50% loss the second year. What is your average annual percentage return for the two years?
Would your first step be to subtract from the 100% first-year percentage gain the 50% second-year percentage loss? The result of that calculation would be 50%. Would you then calculate the average return for the two years by dividing this 50% by two? The result of that calculation would be 25%.
In summary, based on this calculation method, your average annual percentage return for the two-year period would be 25%. Now, here’s the important question: Does this statistic reflect reality?
Well, let’s do an acid test. Let’s assume our original investment was $1. One dollar increased by 100% in the first year, as per our above example, grows to $2. Now we calculate the 50% loss that we assumed for the second year. Reducing $2 by 50%, that is, by half, leaves $1 remaining. Result: we begin with a dollar investment and after two years we have exactly the same amount. Our true return for the two year period is nothing. Nada. Zilch. Goose egg. Snake. Zero. …NOT 25%!
The little exercise above may seem obvious to some readers and opaque gobbledygook to others. Either way, that’s okay, as long as you see the main point: that even a statistic as simple as an average can be grossly misleading. [For readers who do understand fundamental statistics, the principle illustrated here is that percentages with different bases should never be averaged. But, of course, they sometimes are.]
A closing comment about statistics. The average annual temperature in Shreveport and Bossier City, Louisiana is approximately 65 degrees Fahrenheit. This is a correct statistic. But does it tell you all that’s relevant? For example, it tells you nothing about the fry-an-egg-on-the-sidewalk afternoons of July and August, and nothing about the occasional January or February ice storm.
Applying this principle to the financial world, ask yourself the following questions. How important, really, are fifty and hundred year averages when your personal financial time horizon is much shorter? And even more to the point, how useful is any average during unusual times? Wouldn’t a more useful statistic be one that tells you what the extremes have been, good and bad, and how often either extreme has occurred, and about any pattern in those variations? While you are not likely to find these more sophisticated statistics in the general press, they are available from a qualified, conscientious financial professional, and so are clarifying explanations.
Of course, dear reader, no amount of historical fact or analysis or interpretation will ever tell you the future with certainty. The good news, however, is that you don’t have to know the future to prepare for it.
Ernie McDaniel is a Chartered Financial Consultant and President of McDaniel Financial. He can be reached at 318-798-9022.
