Remember the Calamity of the Great Market Tsunamis

To understand the difference between expecting the average and planning for a long, safe life, look no further than the beautiful ocean communities of Japan. Picture a small fishing village with the local economy built around the sea. A colorful pagoda stands in contrast to the green mountain backdrop with a snowy white peak. Kids play in the water, as a Zen Buddhist painter contemplates the waves.

The interesting thing about quality art is its sense of history, and there’s perhaps no greater theme in Japanese art culture than the topic of waves. For example, the title image is a famous woodblock print called The Great Wave off Kanagawa by the artist Hokusai in 1831. It depicts a fierce tsunami off the coast of Mt. Fuji, and is memorable not just for its beauty but also for its deep local meaning. As an island on the Ring of Fire, Japan knows a thing or two about the impact of tsunamis.

The typical day in coastal Japan is quite wonderful, with people congregating around the average sea level. But wander up the nearest mountain and you may find an old stone that looks like this.

Placed after a deadly tsunami killed untold numbers of people in 1933, this one reads:

“High dwellings are the peace and harmony of our descendants. Remember the calamity of the great tsunamis. Do not build any homes below this point.”

Even the seemingly most peaceful ocean can quickly turn deadly with a single earthquake. And to this day, many locals heed these old tsunami stones to stay safe from harm. Historical markers are the guideposts that help them see beyond the average times and survive the worst.

To fight through the hectic modern culture and apply some of that Zen mindset to investing, I think it’s helpful to similarly seek any financial tsunami stones on the market shoreline. They’re all around if you just know where to look. So grab a cup of tea, and let’s talk about the impact of rolling investing waves.

Water is Unpredictable

There’s probably no statistic in investing as ubiquitous as the average return. It’s easy to calculate and understand, and countless portfolios have been constructed over the years with the goal of maximizing the average.

But the thing about averages is that they hide lots of important information. A pool next to the ocean may have the exact same average water level, but the swimming experience couldn’t be any more different. The pool may be glassy smooth while waves fueled by distant offshore storms batter the coast with powerful swells. Treating the ocean with the same casual mindset of a lazy nap on a floating pool chair can get you in serious trouble.

Just like the ocean, markets are always moving. To understand the importance of variability in the average, investing researchers commonly refer to a statistical measure called standard deviation. Just think of it as the typical size of the waves. A small standard deviation means that ripples are very close to the average, while a large standard deviation means that the waves mean serious business.

You can see that in these Annual Returns charts for US large cap blend stocks and 10-year treasury bonds (I’ll just refer to them as “stocks” and “bonds” from here to keep it simple). Standard deviation measures the typical spread of outcomes on either side of the average, and the value for stocks is nearly double that for bonds. So bonds are the calm waves and stocks are the tall whitecaps that can wipe you out if you’re not paying attention.

The thing about markets is that desirable high water levels tend to correspond to choppy seas. For example, here’s a custom version of the Risk and Return chart that maps the average versus the standard deviation for various combinations of stocks and bonds.

There’s a slight curve at low percentages of stocks where a little extra return actually reduces the standard deviation, but for the most part the bigger the waves the higher the average. And in case you’re wondering, this isn’t just a US phenomenon. Here’s the same chart for a few other countries like Canada, the UK, and Japan.

That ubiquitous relationship between average returns and standard deviation has led to the near universal conclusion that I’m sure you’ve heard before. “The higher the risk the higher the reward.” And countless tomes have been written on topics like establishing your “risk tolerance” which usually involves finding the largest size of waves you’re comfortable navigating in your personal investing boat.

That’s all fine. But the thing I personally think is far too often overlooked is that nobody actually receives precisely the average. Many people will receive more than that, and far more people than anyone wants to talk about receive much less.

Also, another issue is the problem of getting a little too comfortable to the point where you think you have your perfect risk tolerance measured and are not prepared for curveballs. What happens when you feel perfectly comfortable on the water when an earthquake happens?

That’s when things get really interesting.

When the Tsunami Hits

The idea of preparing for worst case scenarios certainly isn’t unheard of in investing. The classic example is the concept of the safe withdrawal rate that measures the worst retirement outcomes to help people safely plan their long term retirement budgets. I’ve written extensively on that topic recently (see here and here), and it’s worth your time to read it all especially if you’re in or near retirement. But for the purposes of this article I want to switch gears and talk about accumulation.

Averages are certainly seductive. But when you think beyond averages and start tracking actual real-world outcomes for portfolios that experience compound growth over time, the spread of outcomes is way wider than you probably think. For example, here’s what the Target Accuracy chart looks like for US Stocks.

The straight gray line follows the smooth portfolio growth implied by a constant average return. The blue and red areas, however, show the range of real-world portfolio values for people who simply started investing in different years since 1970.

I’ve marked the outcomes at 15 years, as that’s a nice benchmark for long term returns. In 15 years time, your 3-year old child will be graduating high school and the iPhone can evolve from version 3 all the way to 15. In an age of instant gratification, it feels like an eon.

Look at the values along the bottom of the chart. With a difference in inflation-adjusted portfolio values between the best and worst outcomes of about 8x, you can start to appreciate the problem with only looking at the average. Those market waves aren’t just about enjoying a comfortable ride. They have a measurable impact on your long term journey. And the minimum (only a third of the average) is what your brokerage account looks like when the tsunami hits.

Wouldn’t you like to know that before building your portfolio village on the shoreline?

My favorite reference point here is the baseline return. It’s the 15th percentile outcome, which means that 85% of the time the return was higher than that. The 15-year baseline return in particular is my preferred metric for a conservative long term expectation that is highly likely to meet your planning needs even in dangerously choppy seas. It’s not exactly tsunami level, as that’s admittedly rare. But it stood strong even in your above-average hurricane.

The fascinating thing about thinking in terms of baseline returns instead of averages is that it challenges the engrained bias towards the benefits of taking on as much risk as possible. Remember the chart we showed before that mapped the relationship between standard deviation and the average? Here’s another one showing standard deviation and the 15-year (Long Term) baseline return.

That’s much different! And just like before, the pattern is not completely US specific. Check out the other countries, too.

While they’re all unique in their own ways, they still share one thing in common. When you study actual investing outcomes below the average, lower percentages of stocks have resulted not only in lower standard deviation but also in equal or higher long term returns. Consistency has its benefits, and they are most visible when times are tough.

That may seem completely counterintuitive, and that’s ok. The human brain is just not particularly good at understanding uncertainty, which is why simplistic things like averages are so appealingly sticky. But the numbers don’t lie, and anyone concerned about risk management in their own portfolios owes it to themselves to exercise their thought processes and expand their horizons.

The ocean is perilous. And when the dangerous waves inevitably arrive, the average sea level goes out the window. If the goal is to thrive in all outcomes rather than just ride the waves until you sink, there’s clearly a sweet spot in risk taking that is well below 100% stocks.

To be clear, every portfolio is different and you definitely should not jump to any conclusions from these charts based solely on the percentage of stocks on your portfolio. But the larger lesson is universal.

The average is just a generalization that poorly prepares you for navigating the real world. At some point high waves are measurably counterproductive, and intelligently planning for the hard times can improve not only the experience but also the endpoint.

Heed the Warning Stones

Because of the long timescales involved relative to our individual investing timelines, the proper risk-adjusted balance is admittedly not always self-evident. So it requires looking beyond averages to the experiences of investors that came before you. Metrics like withdrawal rates and baseline returns are thus like financial tsunami stones that stand as stark reminders for anyone wise enough to pay attention.

You may study the shoreline for decades and feel you have it perfectly figured out. The average acceptable. The patterns predictable. In your moment of intellectual pride, the old stone monument on the mountain may seem like an artifact of a different era that can be easily written off as a myth. The world today is a different place!

But one day the earthquake will happen again, and your own personal experience to date no longer matters. Will you be the one looking up at the oncoming wave or looking down?

“High dwellings are the peace and harmony of our descendants. Remember the calamity of the great tsunamis. Do not build any homes below this point.”

As you plan your portfolio foundation, take a few moments to study results beyond the average and think about how you can learn from the worst cases on record. The data is all at your fingertips, like a map to each tsunami stone in the region. It’s just up to you to plan accordingly.

Build your home wisely. Your future dry self may thank you later.