Averages are not only ubiquitous but they are part of popular psyche
Just like we don’t need to understand inflation for it to trouble us, we really don’t need to be able to spell statistics for it to rule us. The realization of an average lifespan could have pushed many saints towards the spiritual path, but for us simple material investors, our life moves around a statistical average.
What is a statistical average? Starting from the average salary, to the average rate of monsoon, to the average run rate of MSD, to the average of Dow Jones Indices, averages are not only ubiquitous but they are part of the popular psyche. Now, this is where the problem begins. You can take a man out of Delhi, but you cannot take Delhi out of him. Habits are hard to change. And these habits are generational. How could we first understand something intrinsic, then challenge it and then eliminate it? It’s an impossible feat. The average is a part of society’s erroneous functioning.
Before we see “why”, let’s dig in a bit of etymology. An early meaning of the word average is “damage sustained at sea”. An average was about assessing an insurable loss linked to a damaged property. Strangely our case against the average here too is about how anchoring on an average is a loss-making proposition for the economic man, even today.
Why erroneous? “Nature was never about equality, it was always about proportion. If weather over the long term does not have an average, the idea of an average return for the stock market is redundant.” Society loves status quo and hence the benchmarks that come with it. We are in love with the average because of the comfort we get from it.
The reality is far diverging from an average, averages are moving and have life, are dynamic and not static. The black swans, the outliers, the freak accidents, the successive luck, the toss of a long sequence of heads in a toss, the fat tails are just too frequent not to wash off the illusion of an average. This is why the average compensation, the average lifespan, the average monsoon, the average temperature, the average portfolio return are redundant expressions.
This redundancy hides under a generational inability to identify the ridiculousness of the “average”. The behavioral finance conflict we highlighted recently (Ranking Global Indices), used both sides of the same coin to challenge randomness. De Bondt and Thaler talk about patterns of performance mean reversion (winners lose and losers gain) in 36 months while Robert Shiller talks about societal feedback causing unexplained repetitive fluctuations. The fluctuations challenge efficient markets (or market moving around an average). Even ideas like gambler’s fallacy and anchoring (we anchor to a visible average when making decisions or forecasts) only created further confusion whether the behavioral experts were highlighting inefficiency (markets not moving around an average) or were they just illustrating the human folly of living around the “average”.
On one side behavioral finance challenged the “average” thinking, but on other side gave undue focus to identify popular psychological biases. Should we not have blamed the flawed “average” rather than the human psychology in the first place? This is where we get into new age thinking. The idea of flawed psychology vs. flawed “average” can only be grasped by a trained mind which uses an average as a guideline at times and knows about its redundancy on other times.
Changing the society’s interpretation works against the needed chaos, but because making sustained wealth is about training, the idea of the life of an “average” has to be grasped by the smart investor. In an SSRN paper on relative strength and portfolio management, John Lewis explains how working with relative momentum (buying strong above average performers) strategy is good for a three- to a six-month period but not good for one month and larger periods above nine months. For longer periods buying above average performers (outperformers) fails.
So, if you have to succeed as an economic man, you have limited options. You have to look at catching a trend if your holding period is three to six months and for an extreme short term and more than nine months holding period, you have to be ready for counter-intuition. In the end, your life is spent either playing above average or below average but never at the “average”.