Understanding The Numbers

My 4 year old daughter Maggie can now count to 27. She reminds my wife and I about her ability every 15 minutes. What doesn't make sense to me is if she can make it from 7 to 8, and 17 to 18, why can't she make it from 27 to 28? She's a bit confused when I attempt explaining my logic. Talking with her made me realize everyday numbers we often take for granted can produce confusing results as well. In this blog post we'll look at examples of numbers are reported, and how those numbers can be misinterpreted.

What You Didn't Know About The Weather

The % chance it will precipitate can be easily misunderstood. Does a 50% chance of snow mean you have a 50% chance of receiving accumulation, or does it mean that 50% of their reporting area will receive accumulation? That small difference in language can yield a slightly different result. According to the National Oceanic and Atmospheric Administration (NOAA), when a meteorologist says there's a 50% chance of snow, it's represents a combination of confidence as well as a percentage of coverage area. They cite an example where a weather team is confident only 80% of the coverage area, and there's a 50% chance of snow. That would equate only to a 40% chance of snow. See how 50% can produce different outcomes?

How Investment Manager's Performance Is Reported

Last week Paul Merriman, retired financial advisor and contributor to the Wall Street Journal, wrote an article regarding investment performance. He compared "average" returns to "compound" returns. Here is the math:

From 1928 through 2014, the S&P 500 has achieved a compound return 9.8%. If you're a long term investor, you might have a 40 year investment time horizon. Applying that time period to stock market returns since 1928, the average of all of those rolling 40 year periods is actually 11.8%. For obvious and convenient reasons, average returns represent an attractive metric to use in advertising performance.

Why We Need To Interpret Investment Returns Properly

Like the weather, the method of calculation can influence what we actually experience. Here's a second example to drive the point home:

If you invest $1,000 and it goes up 50% in the first year and then drops by 50% the second year, the average return was zero — leading some people to think you broke even. But you didn't. At the end of the first year you had $1,500; at the end of the second year you had only $750. That's a cumulative loss of 25%, or a compound loss of 13.4% a year.

In this example, the difference between returns is a pretty big margin. This difference is why many investor's actual returns, measured by the increase or decrease on their account statements, can be very different than what the media reports the market did. It's not that anyone is necessarily trying to dup us, it's simply a difference in the math.

Summary

Recognize that actual results (compound returns) will be different than what you're hearing in the news or researching online (average returns). When researching investment performance, it's best to know via which method your numbers are being calculated.

Thanks for reading and have a great weekend!

P.S. Although sometimes the tougher pill to swallow, I use compound returns (I also account for fees assessed) in my individual performance reports for clients. This return reporting methodology best represents the actual experience. However, I use annual returns in my portfolio model advertising on this site. It's impossible to customize this based on the timing of portfolio entry as well as varying fee schedules for different size clients.