9 ms·
Since I don't see anyone else mentioning this: The geometric mean (6.9) is all that really matters for investors, not the arithmetic mean (8.4) - the arithmeti
by LanguageGamer 4y ago
Since I don't see anyone else mentioning this:
The geometric mean (6.9) is all that really matters for investors, not the arithmetic mean (8.4) - the arithmetic mean under-weights the importance of negative years to long term performance.
For example, if the market is down 20% one year and up 20% the next year, the arithmetic mean will be 0%, but you'll be down 4% (0.8*1.2 = 0.96), which is reflected in the geometric mean of (about) -2%.
- Retric 4y agoDepends, dollar cost averaging shifts things around. For a typical 401k style investor having down years mid career improves returns at retirement, but then increases risks in retirement.
- tunesmith 4y agoThe average investor also has less money to invest during down years though.
- scarface74 4y agoThe “average” investor gets paid cash and not in stock. The public tech company employee has less to invest because a large portion of their income is in stock. The private tech company employee is screwed because statistically, they have equity that won’t amount to shit in a bull market let alone a bear market.
- loeg 4y ago> The “average” investor gets paid cash and not in stock. Not if they're unemployed, which is more likely in down markets.
- majormajor 4y agoThe "average" investor is in jobs less hit by typical recession/down market impacts, since the odds of a hospitality worker or barista having a retirement account in the first place is much lower than the odds of a white collar employee.
- scarface74 4y agoWe have an existence proof that the stock market being down is not correlated with widespread unemployment
- Godel_unicode 4y agoSo far, in this one specific downturn, sure. There is however a strong historical correlation between market downturns and widespread unemployment.
- scarface74 4y agohttps://blog.tornado.com/the-stock-market-is-not-the-economy-4ea9b349aaf6 https://blog.tornado.com/the-stock-market-is-not-the-economy...
- Godel_unicode 4y agoThat’s not responsive to what I said. It’s a snappy one liner though, so I guess cool?
- scarface74 4y agohttps://seekingalpha.com/article/4170913-unemployment-rate-and-stock-market https://seekingalpha.com/article/4170913-unemployment-rate-a... > An inverse relationship between level of unemployment and forward stock market returns. In the current quintile (2.5% to 4.4% unemployment), the average S&P 500 return over the following year is 5.6% versus and average of 12.7% in all periods. The best returns historically have come after periods of high unemployment
- Godel_unicode 4y agoAgain, cool, also unresponsive to the what I wrote.
- 4y ago
- Retric 4y agoThe point of comparison would be average reduction in investment vs average reduction in stock price. It’s true people invest less, but stocks take much larger drops than the reduction in the workforce.
- bunabhucan 4y agoThe average investor includes people who lose their jobs during downturns.
- scarface74 4y agoWhat’s the unemployment rate - right now?
- YPCrumble 4y agoHow would that increase risks in retirement?
- cj 4y agoIt shouldn't if you transition to heavier weighting of cash/bonds as you approach retirement (which most people do and most financial planners advise)
- Retric 4y agoWhen spending down money you get the reverse of cost dollar averaging. In a good year you might sell say 1,000 shares but in a down year you might need to sell twice that to take out the same money. This means more of your shares are sold in down years than good years. This is why people say to increase the bond ratio in retirement, but that also reduces expected returns.
- aynyc 4y agoNot completely as typical 401K investor would change their allocations from equity to non-equity.
- kortilla 4y agoNo, the typical 401k investor does not change their allocations.
- theandrewbailey 4y agoTarget-date retirement funds automatically do.
- adastra22 4y agoAnd even these days the typical investor probably uses a financial advisor, who would do such fund reallocation, even if they don't use target date funds explicitly (which they should).
- FooBarBizBazz 4y agoDo they really? When I've looked around at financial advisors they've wanted at least several percent annually of AUM, which, to my mind, is just insane.
- adastra22 4y agoI agree. I don’t use them myself. There are few-only financial advisors though, which are all I’d recommend people use. I’m just saying financial advisors are common. Not that they should be.
- kortilla 4y agoOnly when you’re getting close to the target retirement date. Even those funds benefit from downturns early to mid-career.
- 4y ago
- zeckalpha 4y agoWith DCA you have the additional costs of keeping cash around. Unless you mean serial lump sum (investing when you get paid).
- nonethewiser 4y agoThat's typically why people DCA. Besides, isnt the opportunity cost is completely independent of the return you're getting from the sp500?
- zeckalpha 4y agoSerial lump sum is not quite DCA. Both involve a series of purchases. The opportunity cost is the inverse of the S&P500 in that case.
- deleted 4y ago[deleted]
- getToTheChopin 4y agoAgreed. Using an assumption of 5-6% annual real total returns is more reasonable for financial planning.
- xapata 4y agoI use a more modest 3.5% real return estimate. I'd rather wind up accidentally rich than accidentally poor.
- Ntrails 4y agoI would describe 3.5% real as pretty reasonable, I would not even call it overly conservative
- getToTheChopin 4y agoThe geometric average return of the market is 6.9%, factoring in the re-investment of dividends and inflation (i.e., the real total return). Based on this, I'd consider a 3.5% return assumption over 20+ years to be conservative.
- Ntrails 4y agoFirst, please repeat the standard mantra: past performance is no guarantee of future success. Then tell me the 95th percentile and the median geometric returns based of fixed periods (say, copy the 20 years.) Let us also grab what an inflation linked gov bond would have given over those same periods. Classically I would always think of pension returns as vs the risk free rate (heh, us gov credit risk) which is essentially an IL bond. Then repeat the analysis on, say, the G8 or G20 countries. Oh, and lets do a variety of stock indexes as well. I am a great believer in diversification - so betting on the US is not my standard behaviour. 6.9% assumed return is mad for any individual. It would be mad for a DB scheme _and they at least have some risk pooling in their favour_. But. I am hella risk averse and see the world through that lens.
- 4y ago
- fallingfrog 4y agoCorrect, because we're averaging together things that are multiplied, not things that are added. Arithmetic mean is rather meaningless here.
- getToTheChopin 4y agoThe arithmetic mean gives you a sense of the return you can expect by investing in the market for a single year. When investing over multi-year periods, the geometric average is more relevant. You can see the impact on this chart, where the average return (and volatility) drops over longer time periods: https://themeasureofaplan.com/wp-content/uploads/2023/01/Rolling-Returns-1074.png https://themeasureofaplan.com/wp-content/uploads/2023/01/Rol...
- chazeon 4y agoInteresting, I am looking at (1+x) * (1-x) = 1 - x^2 < 1
- danuker 4y agoWhat really really matters is the Kelly criterion, or expected logarithm of wealth. If you expect returns to be similar to the past, that would be mean(log(1+return) for every year).
- Galanwe 4y agoInvestors tend to think in terms of 1) volatility 2) exposure/diversification. 1) What _really really_ really matters is the Sharpe Ratio, as in "how much returns you get per unit of volatility". The returns themselves are meaningless if not compared to the volatility to earn them. Also, you want to discount the risk free rate (at least), as your benchmark. 2) The market as a whole is the biggest exposure you can have, you'd want to discount it as being X% of your portfolio
- danuker 4y agoThe Sharpe ratio gives you a good score if you lose everything (-100%) and then you gain a 20% return for 10 years. But once you lost everything, there is no capital to invest, so the score should be infinitely bad. Arithmetic averages are dangerous in geometric environments. Use the expected log-return or the geometric mean instead of the arithmetic one in Sharpe's formula. But maximizing log-return was proven by Kelly to be optimal, and you don't need to further penalize volatility.
- geysersam 4y ago> But maximizing log-return was proven by Kelly to be optimal, and you don't need to further penalize volatility. Unless you are risk adverse. Which it's probably rational to be.
- FooBarBizBazz 4y agoThat's the thing. The Sharpe Ratio looks at a catastrophic situation and says it's ok. It's not appropriately scoring risk! Let's say the risk-free rate of return is 3%. Asset 1: Every year, with 99% probability you get 8% return, and with 1% probability you get -100% return, i.e., you lose everything. This has an expected return of 7%, which is 4% above risk-free; the standard deviation is 0.1; and the Sharpe Ratio is 0.36. But the exponential of the mean log annual multiplier is zero; you will eventually lose everything. Asset 2: With 90% probability you get the risk-free rate of 3%, and with 10% probability, you get a 10,000% return (multiply balance by 101). Yes, this has a good average return of 1,000%, but it also has a giant standard deviation of 30, so its Sharpe Ratio is slightly worse, at 0.33. But, the exponential of the mean log multiplier is 1.62, which means that over time it will have a 62% annual return. Moreover, it literally never goes down; there's no risk. Asset 3: You just take the "risk free rate of return" at 3%. Surely, the best choice is Asset 2. It's literally Asset 3 plus free lottery tickets. But it has the worst Sharpe Ratio of the three. And Asset 1, which has the flavor of some prudent tradeoff, is actually guaranteed to bankrupt you eventually.