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Graph of the week

Graph of the week

19-01-2018 | Insight

There's no such thing as average!

  • Jeroen Blokland
    Portfolio Manager, Robeco Global Allocation team

Ask any ‘stock market guru’ early in the year how the markets will perform and you'll probably get an answer along the lines of: ‘somewhere between 5% and 10%’. Rarely will you ever hear: ‘You know, the usual, more than 20%’, or ‘-20%, probably’. But actually, these are more obvious responses than the rather conservative 5% or 10%.

The graph below shows the Dow Jones Index calendar year returns dating back to 1900, ranging from the worst year on the left to the best year on the right. These returns have averaged 7.4%. Once you know that, of course, expecting a return of somewhere between 5% and 10% suddenly doesn’t seem so strange at all. Just add a bit of margin to the average, and it will come out about right. Except it doesn't.

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If we take a closer look, we see that since the beginning of the 20th century, calendar year returns have only ended up between 5% and 10% on ten occasions (the black columns). Ten times in 118 years! That works out to only once every 12 years. While averages may be interesting statistics, you don't often come across them in practice. So stock market gurus who offer up predictions of between 5% and 10% will almost always be wrong.

In fact, you’d be better off playing the incurable optimist. If you had consistently predicted a return of more than 20% for each upcoming year, you would have been right no less than 31 times. Note that in 2017, the return also exceeded 20%. So this projection, which is much too optimistic to be taken seriously, would actually have been correct 25% of the time. That's three times as often as the insipid ‘guru prediction’ of 5% to 10%.

But what about the doomsayers? The permabears? Believe it or not, even they would have done better than the gurus. If you had dared to predict a return of -20% or worse for each of those years, in eleven cases, you would've been right. So the doomsayers would’ve scored one point more than those who chose to play it safe.

Therefore, our conclusion should not be that there are too many true optimists and doomsayers active on the market, but rather, too few. Too few investors factor the historical return distribution into their predictions and bet either on huge profits or sizable losses. And in a way, that's understandable. After all, if you predict the markets will go sky high in a year in which stocks take a nose dive, it won’t, of course, help your ‘guru’ status any.

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