How can a 6-feet tall person drown in a river of average depth 5-feet?
Ofcourse he can.
Obviously, the first condition is that he doesn’t know how to swim. Second condition is that there is no one around to save him.
But more important is the fact that a river of average depth 5-feet is not deep uniformly. It can be 2-ft deep at one location and 7-ft at another. It can be 4-ft at one place and 12 or more feet at others.
But ofcourse, the average will be 5-ft. So if you are 6-ft tall, you can still drown in a river of average depth 5-ft. 😉
Howard Marks is a billionaire and one of the wisest value investors out there. He once said:
“Never forget the 6-foot-tall man who drowned crossing the stream that was 5 feet deep on average.”
“The important thing to remember about investing is that it is not sufficient to set up a portfolio that will survive on average. The key is to survive at the low ends.”
If you are comfortable with basic maths, you would know that averages don’t show the complete picture.
The river-example clearly shows that basing your decision on information that average depth is 5 feet (which is indeed correct) – can kill you if you don’t know how to swim and are in a part of the river that is deeper than 6 feet.
All this doesn’t mean that averages are wrong. It only means that you need more information to base your decisions on.
Lets take investments as an example:
We are generally telling each other that stock markets can give 12-15% average returns in long term.
But many people don’t take the advice in right spirit. They forget that an average of 15% does not mean:
Year 1: 15% Returns
Year 2: 15% Returns
Year 3: 15% Returns
Year 4: 15% Returns
Year 5: 15% Returns
Year 10: 15% Returns
This never happens. Stock markets are not bank FDs with fixed returns. 😉
15% average returns might in reality be made up of following sequence of returns:
29%, 9%, 17%, -19%, -4%, 57%, 5%, 20%, 15%, 39% – (lets call it Reality 1)
Or there can be another sequence that also gives 15% average returns.
-2%, 38%, -17%, 46%, -10%, 20%, 38%, -5%, 35%, 29% (lets call it Reality 2)
Now here is a graph that shows you what’s happening – assuming that Rs 1 lac was invested initially and investment was held for 10 years:
Assumed return of 15% and returns of Reality 1 and 2 – all end up with same final value, i.e. 15% annual average returns.
But the paths taken are not smooth in reality (1 & 2). The sequence of returns can be different as show in graph below:
One look at the above graph tells that reality of stock markets is uncomfortable. And there is no denying it. Stock markets don’t move in straight lines. But as investors, we need to start getting comfortable with the uncomfortable, if we want to make money in the long run.
If you are unable to accept such volatility, then you should not be in stocks. Though it is this volatility that is the best thing about stock markets.
Now lets see how people screw up when things don’t go as expected.
Suppose an investor decides to invest Rs 1 lac for few years. He has heard that markets can give 12-15% ‘easily’ and hence, makes the investment.
Now he knows the average is about 12-15%. For calculations, lets keep it at 15%. Now using 15% average returns, he believes he will get about Rs 2 lac after 5 years (left table below). But markets, inspite of doing very well in first 3 years, do poorly in next 2 years. Result is that he ends up with returns of just about 5% (right table below):
This investor, obviously unsatisfied with results, might decide to call it quits with the market. But that will be a mistake.
But had he stayed on for longer (and that’s assuming he was invested in good stocks / funds), its possible that markets ‘would’ have done better and he would have attained his expected average returns (see table on left below):
Ofcourse I have intentionally used a sequence of returns that justify what I am saying.
But that is how it is.
Reality is volatile and you need to accept it. It is uncomfortable. But no one said successful investing was easy. Its simple no doubt. But sorry, its not easy.
You should be prepared to accept ‘reality’ (i.e. actual returns) that are not in line with your expectations (i.e. expected returns). More so if you are not investing for long term.
Ideally 5 year is the bare minimum that you should be prepared to stay invested in equities if you want to make decent money. But even then, its not a guarantee.
Just because markets did well in last couple of years, does not mean that this trend will continue forever. Infact, statistically speaking and using the concept of mean reversion, chances of having a bad year after few good ones is quite high.
So use common sense and understand the basic nature of market. Markets are like trains. You don’t want to come in way of a train. Rather, you should try to ride it to your destination. 🙂