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April 13, 2015 at 04:34 AM
One of the most fascinating things about markets is the sheer volume of data they generate. Every day, millions of data points get created. The vast majority of this amounts to little more than noise. This endless stream of information leads thousands of us everyday on a hunt for meaningful signal amid the cacophony.
Most of the time, we are unsuccessful. We can be tricked into seeing significance where none exists. Our pattern recognition engines are fooled by what turns out to be mere randomness (there’s a good idea for a book in that). There is a meaningful needle buried somewhere in the haystack of numbers, but we underestimate both how hard it is to identify, and just how huge that stack is.
As an example, let’s take a number we are all familiar with: Average market returns. Depending upon the period of the data set under discussion, we usually envision a long-term annualized compound return of 8 percent to 10 percent.
Have a look at the chart below:
Source: Dimensional Funds
It shows the distribution of returns of the Standard & Poor’s 500 Index going back to 1926. During the course of the 89 years covered by the chart, we never had a single year when the annualized compound return was simply the average! This means that if you are expecting your returns to fall somewhere around 8 percent to 10 percent in a given year, you have — at least so far — been disappointed.
The market has, on occasion, been in the neighborhood of the median annual return of 14.3 percent, or the average annual return of 12.1 percent. But the occurrence is infrequent — less than 1 out of 10 years.
Average, as it turns out, is surprisingly rare. Radical standard deviations year-to-year only even out over long periods of time. In any given year, markets are much more of a roller coaster than the averages might suggest.
