Investment Outliers can Kill You

My company sets aside a percentage of my salary each year (based on company performance) in what’s called a money purchase investment plan. I can invest that money however I choose, mostly. Stocks, bonds, mutual funds. Maybe gold (I’ll have to ask).

So the other day I’m trying to figure out, based on my current salary, what kind of return I would need in order to amass a million dollars by the time I’m 55. In my analysis I did what all good people do nowadays. I Googled. I was looking for the “average stock market return rate”.

The answer? All over the place. Returns showed everything from 8% to 15% over the last 100 years. Does that mean if I buy a market index now and wait 20 years I should expect to receive an average return somewhere between 8% and 15%? Not exactly.

The only thing we can take away from historical stock market returns is that buying and holding has worked in the past and will most likely continue to work in the future. Or so the saying goes.

Carl Richards from Prasada Capital, writing in the Bucks Blog at the New York Times online, throws a little rain on the buy and hold parade using the concept of outliers.

“In theory, an outlier is something that is so unlikely that it is thought to be unrepresentative of the rest of the sample. In this case, these outliers generate returns that, according to the theory, we are almost never supposed to see.”

He continues by stating…

“When something is never supposed to happen, we don’t spend much time thinking about it. Instead we focus on the average.”

In terms of investing, this works out well because we’re not concerned with yearly performance. Why would I be concerned if my investment horizon is 20 years or longer?

According to Richards, I should be concerned.

“The problem is that average is not normal and focusing on it leads us to greatly underestimate the impact that these outliers can have when they do show up.”

But, in reality, these outliers, these non-normal returns that I shouldn’t be concerned with…

“…have such a huge impact that they actual obscure the importance of the average…

If you take the daily returns of the Dow from 1900 to 2008 and you subtract the 10 best days, you end up with about 60 percent less money than if you had stayed invested the entire time. “

Ten days. Ten days out of 108 years. Can you think of ten days in your life that would have this colossal of an impact on your finances? Hard to imagine.

So, what if you remove the ten worst days? You would have ended up with three times more money. So, my million dollars would be worth three million. Ten days.

Read the entire article on the NY Times Bucks Blog.

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