At certain points during our routines we invariably have conversations about the elusive averages surrounding us.
For instance, according to CBSSports.com the average Major League Baseball Players Salary in 2012 is $3,440,000 or the scoring average of the leading money winner on the PGA Tour in 2012 is 69. These conversations usually become the basis for our comparisons.
The problem with averages is their meaningless nature.
There is a clever phrase that sums up everything needed to understand about an average. A person can still drown in a lake with an “average” depth of three feet.
In the financial planning field, averages can be damaging not just to morale, but future success and goal attainment.
An investment’s average return without framing how the average was attained is just as meaningless when trying to assess an individual investor’s personal rate of return.
Any investment will almost certainly have information available to find the average rate of return over 3 years, 5 years, 10 years, etc. time period. This information is abundantly available with the help of the internet. However an investor that stays continuously invested in that security will rarely ever achieve that same published average.
Why is that?
3 Important Variables to an Individual’s Personal Rate of Return
Variable 1: Investor’s behavior
Simply said, how is an individual interacting with the investment via deposits and/or withdrawals. Is the investor dollar cost averaging a systematic deposit throughout time? Is the investor withdrawing systematically to support retirement income? Or is the investor simply buying with a lump sum and holding? These behaviors will impact an investors “average” or personal rate of return. This is a controllable behavioral variable that can be altered by us all.
Variable 2: Allocation of that portfolio or the choice of investment
Is this a stock, bond or a balanced combination? This is something that can be constructed with the investor and financial advisors guidance.
Variable 3: Varying sequence of returns that generate the investment’s average
This is most critical to an individual’s “average” and is the hardest to grasp by most investors because it is uncontrollable by the investor and the financial advisor.
The three different investor behaviors mentioned earlier could invest in the same portfolio for a period of years and each have drastically different individual rates of return, and none could equal the portfolio’s average!
The reality with individual investing can be defined by three factors: cash flow, asset allocation, and sequence of returns.
We are individuals that interact with our portfolios uniquely and during different phases in our lives. The behavior that we inject into a portfolio combined with the design and sequence of returns of that investment will generate totally different outcomes for the individual investor.
Add these three important factors up and it is where most conversations about investment averages should begin but rarely do.
According to Investopedia.com, dollar cost averaging is defined as ‘the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high’. Please be mindful that investing involves risk, including loss of principal, and no strategy can assure success or protect against loss.
Robert P. Pretopapa, CFP®, is a Wealth Advisor with One Financial Services, LLC, located at 1605 N. Cedar Crest Blvd. Suite 515, Allentown, PA 18104. Securities offered through LPL Financial, Member FINRA/SIPC.