I recently read a book called The End of Average. In it, the author told a story about a problem the US Air Force had with their new jets in the late 1940’s. A bunch of them were crashing.
Many potential causes were investigated, including pilot error, mechanical failures, and electronics problems. Eventually the engineers came to suspect something was wrong with the design of the airplanes’ cockpits.
The US Army had standardized the dimensions of their aircraft cockpits to conform to the average measurements of several hundred pilots back in the 1920’s. They wondered if pilots in the 40’s were bigger than back in the 20’s. So, they took detailed measurements of over 4,000 pilots. But the problem remained unsolved until a young lieutenant that had written his college thesis on the hand sizes of male Harvard students asked a simple question, “How many pilots really were average?”
When he analyzed ten of what he felt were the most important variables that had been used to determine the “average pilot” from those that had been measured, he found that ZERO pilots actually measured within the average of all ten of the dimensions such as the size of their arms, legs, chest, and hips. One may have longer legs, while another may have shorter arms, and so forth. Even more astonishing, he found that less than 3.5% of the pilots were average in any 3 out of the 10 measurements.
He concluded that the cockpit that had been designed to fit the “average pilot” was really designed to fit no one, and was contributing to many of the unexplained crashes.
Markets and Airplanes
Investors can learn from this lesson, and it has nothing to do with oft used flying metaphors (soft landings, crashes, soaring, etc.…) that are used to describe market valuations. Take for example the well-known 10% average return of the US stock market since 1926.1 Knowing what we now know about averages, can you guess how many times the S&P 500 has actually returned within 1/2% of 10% since 1926?2
A. 0
B. 2
C. 6
D. 10+
(Answer at end of article)
Yearly results can vary significantly, and in any given period stock returns can be positive, negative, or flat. When setting expectations, it’s helpful to see the range of outcomes experienced by investors historically.
Exhibit 1 shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 Index had a return within this range in only six of the past 93 calendar years. In most years, the index’s return was outside of the range—often above or below by a wide margin—with no obvious pattern. This data highlights the importance of looking beyond average returns and being aware of the range of potential outcomes.
Exhibit 1. S&P 500 Index Annual Returns 1926–2018
In US dollars. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.
TUNING IN TO DIFFERENT FREQUENCIES
Despite the year-to-year volatility, investors can potentially increase their chances of having a positive outcome by maintaining a long-term focus. Exhibit 2 documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the US market. The data show that, while positive performance is never assured, investors’ odds improve over longer time horizons.
Exhibit 2. Frequency of Positive Returns in the S&P 500 Index Overlapping Periods: 1926–2018
In US dollars. From January 1926–December 2018, there are 997 overlapping 10-year periods, 1,057 overlapping 5-year periods, and 1,105 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.
While some investors might find it easy to stay the course in years with above average returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience. What can help investors endure the ups and downs? While there is no silver bullet, understanding how markets work and trusting market prices are good starting points. An asset allocation that aligns with personal risk tolerances and investment goals is also valuable. By thoughtfully considering these and other issues, investors may be better prepared to stay focused on their long-term goals during different market environments.
Get in touch if you want to see how you measure up.
1 As measured by the S&P 500 Index from 1926–2018.
2 B. It has happened, but only twice (1946 and 2016).
Adapted from Dimensional Fund Advisors May 2019 Issue Brief.
There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate the risk of market loss. All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.