Being in the wealth management world I am a prodigious consumer of financial media. I constantly review, study and we on occasion adopt a new idea, which is exactly what I believe clients want us to do in achieving their wealth management strategy. While time-consuming and contrary to actually “having a life”, I do find the sorting and sifting of ideas intellectually stimulating and important. By constantly searching for what is new, another advisor is likely to present something in a new light.
Sound investment strategies are key to a high probability wealth management plan. Once in a while, another advisor presents a concept that is sooo simple but true. You wonder “why didn’t I think of that?” or “this is totally obvious and I’m glad I finally get it”. A recent post by Corey Hoffstein and Justin Sibears of Newfound Research entitled “The Lie of Averages” illuminated something that investors need to think and ruminate on. Here is an excerpt:
How would you design a cockpit? Ever thought about it? We haven’t. (Or, at least, until this commentary, did not give it much thought.)
But the U.S. Air Force faced this very problem back in the 1920s. How high should the windshield be? How far should the pedals be from the stick?
Their solution was to measure 100 of their pilots along a number of physical dimensions (e.g. length of their arms, size of their torso, et cetera). Using these figures, they calculated the average for each dimension and used it to guide their design.
By the 1950s, planes had become faster and more mechanically complex. Yet pilots were losing control of their planes left-and-right.
Military engineers wondered if perhaps the pilots of the 1950s were simply no longer represented by the average from the 1920s. So, they redid the calculations: this time with 4000 pilots and along 140 different physical dimensions.
One scientist – Lt. Gilbert S. Daniels – was skeptical. Perhaps the problem was not with the averages themselves, but with the use of averaging. After all, how many pilots were actually average shaped?
With all the data collected, Daniels took 10 of the primary dimensions and asked a simple question: how many pilots fell within the middle 30% of the range for each of these dimensions? As an example, if the average height of a pilot was 5’9”, how many pilots fell between 5’7” and 5’11”?
How many pilots did Daniels find that fell between this range on all 10 primary dimensions? Zero.
Perhaps that was just too strict a test? What if we chose just 3 of the dimensions? How many pilots fell within the middle 30% of the range for at least 3 dimensions? Just 3.5%.
The cockpits had been designed for an average pilot who simply did not exist. Fitting the average meant fitting no one.
Sometimes, when reviewing a wealth management plan as investors, we look at the averages and expect that result going forward, but the reality is that each year will present an outcome different from the average with almost certainty. Some years the return is above average (to be expected) and it brings joy to our hearts and minds. Other years, the result is below average and we experience fear and disappointment. Both ends of those emotions are irrational as the average is simply the sum of widely varying results and decided over a time period. The likelihood of achieving the average in any one year is practically impossible. There will be above average and below average results just as there always have been.
The importance of using Monte Carlo simulations in our financial plans is critical, not to focus on the averages, but to focus on the potential variability in investment returns and outcomes. We know that the average number is not the expected number each year but the data can help us ascertain the likelihood of realizing our long dreamed about and worked for goals. No, Monte Carlo simulations are not perfect but they can shine a light on the path(s) that are most likely to produce the desired outcome.
For our part in developing realistic financial strategies for our clients, we will continue to survey the landscape and employ the best tools available to produce solid results and help realize your goals and dreams through a comprehensive financial strategy.
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