Your investment performance is a collection of periodic returns through time, but somehow your experience (what you hear on the news, account statements, advisor updates, etc...) is a collection of periodic updates through time.
The market was down 18% in 2022.
The market was up 24% in 2023.
It's easy to assume that if we get -18% in our portfolio one year, and +24% in our stock portfolio the next, that we get a +6% total return, or +3% per year.
But you don't. You end up getting about +1.7% per year.
You don't necessarily need to know how the math works, but you do need to know that how you average matters. And your performance will not match your periodic updates.
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2023 was the hottest year on record for Austin, Texas.
It hit 110 degrees here in mid-August. If not for tacos, it wouldn't be worth living here for long stretches each summer.
But somehow this January, temperatures have been in the teens, and it's literally freezing.
So what's the "average" temperature in Austin, TX?
About 72 degrees. Same temperature that people describe perfect-weather Los Angeles as having. The problem is that averages don't tell us everything, because how you average matters.
Los Angeles always "feels" like 72 degrees, mostly because there's a fairly tight range around 72 degrees. While Austin averages 72, it never feels like 72.
Austin is a head-in-the-oven, feet-in-the-freezer average.
And there's a critical idea that is objectively true for investments, though not necessarily for temperature: as an investor, volatility around an average will erode your returns.
Here are four ways to arithmetically "average" 8% per year over two years:
Start | Year 1 | Year 2 | Average Return | End Wealth |
$100,000 | +8% | +8% | +8% | $116,640 |
$100,000 | 0% | +16% | +8% | $116,000 |
$100,000 | -10% | +26% | +8% | $113,400 |
$100,000 | +100% | -84% | +8% | $32,000 |
Note that the order doesn't matter. Getting -10% and then +26% is mathematically the same as +26% then -10%, and that goes for any returns sequence.
Note also that you can "average" +8% per year, and in the last option, lose over 2/3 of your wealth in two years. How you average matters.
And once investors recognize that, they know that all else equal — they prefer smooth returns to avoid the idea displayed at the extreme in the last option, called volatility drag. The best way to return an 8% average is through consistently getting 8%.
Life, and investing, are full of tradeoffs.
But this is not a tradeoff. You want your portfolio's volatility, all else equal, to be as low as possible.
Whereas weather volatility is a tradeoff. Do you want extremes like Austin, or do you want the consistency of Los Angeles? For some people, seasons and variation can be nice, while others may prefer a reliably temperate climate. Reasonable people can disagree.
As an investor, though, you want smooth returns. The broader distribution of possible outcomes you accept, by doing things like putting a lot of your money into one stock or tactical idea, or timing in and out of the market — the less smooth your expected investment experience.
So if you get cheeky, it won't be enough to be right with a more volatile portfolio, but instead you'll need to be right to an extent that also overcompensates for volatility drag.
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Arithmetically speaking, of course you can track and analyze your periodic updates. It is easily accessible data, and it is how the world reports investment returns. But geometrically speaking, it won't actually be your average.
A person with $100,000, that averages 8% for two years, could end up with any amount between $32,000 and $116,640.
Because how you average matters.
End.
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