Don't make investment decisions based on averages

Talk to any investor and advisor alike, the single most criteria for forecasting the future returns is the average. Whenever we talk about inflation, interest rates or returns, we look back at the history and confer that the average is at a particular percentage.

And if we were to extrapolate that average to future, a certain number is achieved for the projection and/or goal to be achieved. This is the general tendency, but reality is lot different.

The actual returns, inflation or interest rates is never linear or same across each year. Of course, we do have measures like standard deviation to know how volatile or not this average from their extremes.

In the end, we only go with the averages to understand the situation, plan for the accumulation and even use this measure to distribute the corpus.

Market situations are always non-linear, and we see a very high returns for a year and below average or negative returns in another.

Completely depending on the law of averages to arrive at the risk appetite is not quite correct.

Of course, the risk profiler drills us on how one would respond to various market situations, but are we be prepared to accept such volatility in our real lives?

For instance, how would the following annual returns excite you? -5 per cent, 22 per cent, 4 per cent, 13 per cent, -17 per cent, 57 per cent, 10 per cent, 19 per cent, -12 per cent, 29 per cent.

Now, how many investors would be happy if at the beginning of their investments were told that this would be their future 10-year returns. Wonder how many would be willing to invest in such an instrument or avenue.

When annualised this turns out to be an average return of 12 per cent. And yes, when mentioned at the first place most investors would be happy to invest in a 12 per cent return instrument or avenue.

But actual markets are pretty different to our assumptions and we may not know how we would respond at each of those years especially the circumstances that we go through at that time.

Now, let's add up another dimension to these numbers. What if we change the sequence to these very returns and see how it translates to...

For instance, let's make all the best of the returns at the start of the tenure i.e. good returns in the early years and another the opposite i.e. good returns at the later years. Let's compute and then analyse.

Good early year returns: in this case, if a 10,000 SIP (systematic investment plan) of a mutual fund (MF) assumed a return of 10 per cent for first 10 years and then five per cent return in the next 10 years then the investment would translate to a corpus of 58,34,210. The annualised return here is about 8.16 per cent.

Good later year returns: in this case, if the same SIP of 10,000 invested with returns of five per cent in the early 10 years while the later 10 years give 10 per cent returns then the corpus translates to a corpus of 66,50,278. The annualised return here is about 9.3 per cent.

The difference between the corpus is 816,068 which is around 14 per cent higher for the good later year returns than the good early year returns. In both the cases, however, the average return is the same.

Here, the sequence of returns makes for a huge difference in the end corpus. The higher returns later years on the compounded lower capital would cumulate more and thus is the difference.

No, I'm not suggesting taking higher risk for higher returns at the later years of goals like that of retirement, etc.

The result would be different if the sequence of the returns in the first example is different. And what need to realise is that we can't define the sequence of returns we could get out of the portfolio.

The idea is to be understood in terms of risk of risk and the possible fallout of higher volatility that impacts the end results.

So, average returns can't be your only parameter and other analytic parameters like standard deviation, variance, etc. help you analyse better about the risk of an investment avenue or instrument. Investors should be aware of and practice this while making investment decisions.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)