Relying on average theory may not bode well every time
This IPL season, when the cricketers are on the field, our screens are lit up with their statistics. Along with the vitals, their strike rates and averages are displayed. Commentators express their perspectives on their stats, while the spectators take side depending on the players.
This IPL season, when the cricketers are on the field, our screens are lit up with their statistics. Along with the vitals, their strike rates and averages are displayed. Commentators express their perspectives on their stats, while the spectators take side depending on the players. For a player with lesser history, his averages will have tremendous change depending upon this performance, but for seasoned players, the out/under performance has very little impact of that one game. But the player's reputation is mostly derived from his outstanding performances and thus the higher averages.
Similarly, when we tend to make an investment decision based on the past performance and even when presenting a new idea, we try to extrapolate it backwards to see how it did well in the 'back-testing'. And the next important factor that we arrive to compare is the average performance. No investment avenue is planned to perform at an average, but the performance over a period of time is collated to an average return. It's a trailing indicator which doesn't say anything about how a particular investment would do in the future, but certainly gives out an idea of how it possibly could deal a market condition.
Some cricketers are known for their temperament during pressure situations and are considered finishers (of the game) for their consistent performance at crunch times. This doesn't translate to or guarantee a winning just due to their presence at that point of time, but will give us a sense of how they had faced similar situation and possibly help them dwell on that experience to the current situation. It's nothing wrong, but how else is the way to assume or evaluate the performance or a possible performance of a player. Of course, there could be varied number of variables like that of the quality of the opposition, the pitch or the ground and other climate conditions.
Even when comparing investments, we would tend to consider past average as one of the main criteria though variations on the same metrics as standard deviation, variance, etc., could be used further for better comprehension. However, one has to always keep in mind that reversion to mean is a powerful force. A single player or an investment wouldn't remain at the top of their performance all the time. So, averaged do catch up or one tends to make averages.
So, whenever a new batsman comes to the crease and when the statistics display his average, we can't assume the certainty of him hitting at least that average, but it rarely does happen. Imagine when chasing a total, if all the players hit their averages at their historical strike rates, then matches are won almost always, it doesn't happen in reality. The same is with an investment we can't expect it to perform at its average every year or even during the year of the investment.
When relating the Nifty valuations, we tend hear that the current valuation is above or below the long-term average P/E of the broader index. But a closer observation throws out that it rarely traded at its average. It's either always overpriced than the average or underpriced to the average. So, you can't make your investment decision based only on this parameter that the current situation is better or worse than the average. It means the current situation could deteriorate further to worsen. And that's reality where we can't enforce assumed certainties.
Maggie Mahar wrote, 'men resist randomness; markets resist prophecy' and this aptly describes how we look at the world. While, we aspire to end up investing in an outlier, the minimum anticipation is that it should give an average return (i.e. similar to a more traditional investment). This probably explains why we end up taking higher risks than that we could handle. We could be deceived into an investment by its average return than if we could actually plot the real return on an annual basis, which could present a realistic situation of that investment.
While it's important for us to have parameters to evaluate an investment decision, it also should be in tandem with the risk profile and timelines. Arguably, an important trait an investor should possess is the flexibility alters or questions their own thesis according to the market. No, it doesn't mean changing the investment philosophy, but altering the execution.
(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at email@example.com)