When discussing investing options, the single most common referenced metric has got to be the average return. Reams of books and blogs have been written on individual asset classes and composite portfolios with the highest average returns looking both backward and forward, and amateur and professional investors alike spend more time than they probably want to admit thinking about how to maximize their own average return. Long-term averages are both set on a pedestal and also taken for granted, as many people idolize the average to the point where they’re willing to ignore very real risks under the belief that superior performance is inevitable if they only wait long enough.
But what happens when the long-term average return never manifests in your own portfolio even over extended timeframes? Was the data wrong? Did the markets change?
In reality, it’s most likely none of the above.
In my experience the real explanation is something much more fundamental than that. There’s a good chance that you probably don’t understand what the average return really represents and you have even less knowledge of how a real-world portfolio behaves relative to its average. Don’t feel bad — we’ve all been there. Human brains just aren’t wired to innately understand uncertainty and it takes quite a bit of practice to train ourselves to think beyond over-simplified generalizations.
To help re-frame the problem into something that’s easier to understand, let’s forget about finance for a moment and switch gears. We all like Nerf guns, right? Whether its an all-out war with siblings or an impromptu battle at the office, I wager lots of you are familiar with the ubiquitous foam bullets flying across the room. So with finance off the table and only colorful soaring darts on the mind, behold the single best explanation of averages and uncertainty I’ve ever come across that has absolutely nothing to do with money. The video is less than five minutes long, so please take the time to watch the whole thing before reading on.
HOW ACCURATE ARE NERF GUNS?!
By Frank Cooper, Coop772
(I don’t know him and I am not affiliated in any way. I just find his content awesome and think this particular video is a perfect metaphor for investing.)
I absolutely love Frank’s visual representation of the variability of dart flight paths and his explanation for how real-world Nerf accuracy is completely independent of your skill and aim. Imagine for a moment a laser pointer mounted on each gun that paints a perfect target on the average final dart position. Clearly the practical value of that pointer is only as good as the accuracy of the gun.
Applying the same idea to investing, imagine a portfolio of 100% US stocks as a Nerf gun with $10k in initial ammunition. Since 1970 this portfolio averaged a real return (after inflation) of 7.6% per year, so let’s start by calibrating our laser pointer. Here is what the growth path of an initial $10k looks like with a consistent 7.6% annual return.
That’s a simple exponential curve and is a classic visual of how compound returns work, both growing over time and accelerating upward. But to make it a little more laser-like, let’s change the Y-axis to a logarithmic scale. A logarithmic scale represents percent changes as equal distances and helps visualize constant growth as a straight line.
Now that’s a proper financial laser sight!
Next, let’s do the exact same experiment illustrated in the video and map the real-world trajectories of five different shots from the same portfolio of US stocks. Each shot is from a different historical investing period beginning in 1970, 1980, 1990, 2000, and 2010.
Look familiar? Just like how Nerf darts fired from the exact same gun don’t hit the same spot every time, real world portfolio performance also naturally misses the target with each shot. There are just way too many variables involved, and the average return represented by the laser doesn’t tell the whole story.
But with tons of financial history at our disposal, let’s not stop there. What would the chart look like if we tracked every portfolio dart we have data for?
That’s a lot of trajectories, and while the spread is very useful it also starts to get a little messy to interpret. So using a few statistical tricks, let me simplify the visual to highlight the important data.
The above chart sifts through every portfolio trajectory and highlights five data points for each year along the way — maximum return, stretch return (85th percentile), average return, baseline return (15th percentile), and minimum return. Long story short, it summarizes the entire body of portfolio shots in a clean and organized way.
Of course, while a chart like this may be somewhat interesting in isolation it gets a lot more valuable when you can compare the spread of returns to those of other portfolios. Luckily I have just the tool for that. I call it the Target Accuracy chart, and it’s a completely redesigned version of an old chart with the same name. You can think of it as an automated firing range for testing the projectile accuracy of any asset allocation you like.
You can read about each of the features and settings on the Target Accuracy page, but for now let’s stick to the high-level comparisons. The really cool takeaway is that portfolio performance is just like Nerf dart trajectories. While no individual trajectory is perfectly predictable ahead of time, not every gun and dart choice are equally unpredictable. In fact, the portfolio you choose goes a long way towards determining how likely you are to hit your financial target. For example, let’s compare the Target Accuracy charts of a few different portfolios.
Here you really start to see the difference in portfolio accuracy. If the Total Stock Market is the highly common but wildly inaccurate Elite Darts of investing, the Golden Butterfly is equivalent to the Rival Rounds useful for precisely hitting the target every time. The Sandwich Portfolio is something in between, perhaps comparable to the BoomCo Darts. Every portfolio is different and has its own unique flight characteristics.
Also note that the chart includes real portfolio values for each data point. While most investors naturally fixate on the average return and may prefer the Total Stock Market for that metric alone, once you compare the minimum and baseline results it gets a lot more complicated. Real people experienced those results, and you can’t simply disregard them as poor investors for selecting an identical portfolio to the one you’re considering. That real-world uncertainty is the very nature of the weapon, and choosing the right portfolio is the single most important decision you can make when those targets are not pictures on the wall with dozens of darts in the chamber but your personal life goals with your one shot to take.
Circling back to the Nerf video, I particularly like Frank’s summary near the end and think it’s a great lesson for all investors:
“The biggest problem I see with people analyzing their own performance in a Nerf war is the selection bias that’s just everywhere. Selection bias is when you have multiple results but you’re only paying attention to what you want to pay attention to and that just completely skews your conclusions. Meaning that if you take ten shots and nine of them miss and you finally hit then you’re like oh, I was just aiming a little bit incorrectly when in fact you were aiming in the same position but the darts were just going absolutely everywhere.”
So true. And the exact same dynamic plays out in investing every day with hordes of self-identified financial experts proudly sharing the theoretical average return of their own laser sight or the favorable result of their last shot while conveniently explaining away the wild error of the previous nine attempts. It’s not that their aim was wrong before or that they have superior skill today. In fact, if they’re like most people they probably invested in a highly variable portfolio with a desirable long-term average or expected return and eventually got lucky with a single dart.
I don’t know about you, but personally I don’t like the idea of trusting my own financial future to that type of uncertainty. Whether it’s a Nerf war or an investing plan, there’s something to be said for choosing an accurate weapon with a measurable history of hitting the target. And if the projected laser pointer of the average return is a little low for what you need, figuring out how to adjust the aim up with improved savings is a lot more dependable than firing a financial cannonball as high as possible with no idea of where it will ultimately land.
So when building your own portfolio strategy, consider looking beyond the average return to the accuracy of the asset allocation. You deserve better than to bet your entire financial future on the trajectory of a solitary Nerf dart from a wildly unpredictable gun. With the right portfolio, you can break the cycle of perpetual disappointment and readjustment and meet your important financial goals with high confidence and minimum effort.
The Target Accuracy chart is my effort to help you find that portfolio, and with a little practice my hope is that it will help you become a financial marksman with the most accurate tool for whatever target you’re aiming for.