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It's Not What You Think. Market Myths Debunked

"A lie told often enough becomes the truth" - Vladimir Lenin

Imagine for a minute you lived centuries ago when people believed the earth was flat, or the earth revolved around the sun, or that planets were Gods, or that disease was angry spirits or supernatural powers. You'd have an explanation for everything ... only it would be wrong. And that "wrongness" would stand in the way of true understanding and true progress until they were discarded as falsehoods.

And so it is with the Stock Market. Let me explain.

First, let me be perfectly clear. I'm a statistician so I'm not referring to philosophical or political or gut feelings or anything other than Statistical Misrepresentations. Fact, not opinion.

I can hardly go a day without reading an article or hearing a TV pundit or someone regurgitate misconceptions that are so integrated in our minds ... we believe them to be the truth.

These misconceptions cause us to make investing mistakes because we take them as axiomatic when they are fantasy.

I am constantly amazed how often misconceptions about really fundamental aspects of the market persist. Not just amongst lay investors, but pundits and professionals as well. It just seems, at times, that investors WANT to be misled. I guess it gives them some sort of comfort ... even if it is wrong.

So, let's see if we can correct some of these misconceptions.

Let me take the most prevalent ones one at a time.

Average Market Returns:

I have to admit, I came across three articles today that made projections based upon Stock Market Average Returns. They all quote some historic average return over some historic period. In one particular article, the last 10 years was presented as an Average Annual Return of 9.05%.

The Stock Market Average Return is a meaningless metric. And here's why.

Average returns are relevant only if they are independent of each other. An example would help.

Let's say the market went up 15%, then down 15%, then up 15%, then down 15%. The average return is ZERO. But, let's do some math.

Start at $1,000.

1) In year one, the 15% goes to $1,150.

2) In year two, when it goes down 15%, it's down $173 to $977.

3) In year three, when it rises 15%, it goes up $147 to $1,124.

4) In year four, the 15% drop is $169 to $955.

The average is ZERO. The result is negative 4.5% ... or negative 1.125%/year. Reversing the up and down years renders the same result.

This results because Averages only work if the events are independent of each other. When one compares performance to averages it is an apples to oranges comparison.

One must look, NOT at average returns but CAGR (compound average growth rate), which takes into account this interdependence of events.

Let's take a microscope to recent events and see how it works, in real-time, not in theory:

For dramatic effect, I'll use the three year period of 2008, 2009 and 2010.

S&P Average vs. CAGR

2008 - 36.55%
2009 + 25.94%
2010 + 14.82%
Average Annual Return + 1.40%
CAGR - 2.75%

This differential represents a swing of over 4%. No wonder investors have trouble understanding how they lose money when the average seems to make money.

Examining the last 10 years, the "average return" of the S&P 500 was 9.05%, but the CAGR of the market was only 7.25%.

In fact, if we look at slices of returns over the last 100 years, we will find that Average Returns overstates CAGR by about 2% per year. WOW.

Here's a chart that shows the pattern for the S&P 500:

Average Returns vs. CAGR

Average Return CAGR
1928-2015 11.40% 9.50%
1966-2015 11.01% 9.61%
2006-2015 9.03% 7.25%

Remedy: There is a very simple remedy to this misconception. Do not use Average Returns, look instead to CAGR (compounded annual growth rate). That is the only way to judge performance.

Significance: This is a very significant distortion for a number of reasons. If we assume that long range historic returns are indicative of long range future results (I'm not saying they are ... that's for another article). If someone wants to project accumulation goals or withdrawals in retirement, they will severely overstate the results if they use Average Returns rather than CAGR. This is magnified as their projection will use compound interest on an overstated metric. Ye 'ole double whammy.

It also distorts inter-market comparisons, say comparing S&P to DJI or Nasdaq or Small Cap or whatever. When we are presented a distortion of reality, this distortion, when and if, compared to another distortion, well, two distortions don't make a right.

Let me move on to the next myth.

Inflation Rates:

No, I'm not going to argue about whether or not the metric used to determine the CPI or inflation rate is proper. I'm simply going to extend the argument I just made about Averages versus CAGR.

I'm going to save lots of typing by simply stating that when values are substantially unidirectional - that is they are mostly either up or down as opposed to up and down - an Average will understate, not overstate CAGR. Inasmuch as the last 60 years experienced only one year of negative inflation, it is certainly unidirectional.

We always hear about "some" Average Inflation Rate being XYZ. For instance, one Average Inflation Rate for the last 10 years was reported at 1.7%. However, that understated the CAGR when, using the exact same time period and rates would be closer to 1.9%.

Remember, this is statistical hocus-pocus which must be added to any hocus-pocus in the design of the metric, itself.

So, if anyone is wondering why they have trouble making financial progress it's very simple: returns for the market are statistically overstated and the inflation rate is statistically understated.

Moving on to the next myth.

Mean Reversion:

This is mostly used as a fancy way to say "What goes up must go down". In that context, it's more of a mis-application than a mis-representation. However, the effect is just as devastating, as it influences behavior that is inconsistent with maximizing returns.

When the market rises, as it has now, we hear a lot about mean reversion. This seems to make sense and play into the basic investor fear of a retrenchment. To better understand why mean reversion has nothing to do with this, let me start with an analogy.

We see an Olympic 100 meter swimmer dive into the water for her race. As she uses her left hand for the first stroke, she pulls slightly to the left. Then comes the right hand and that stroke moves her slightly back to the center-line. So, what we observe, is constant forward motion that travels in a jagged, or zig-zag, pattern.

Now, if the swimmer mean reverted, she'd go out to the 40 meter line, reverse course, swim back to the 20 meter line, reverse again to the 30 meter, reverse again to the 25 and so on ... back and forth .... until she settled near the 25 meter line and sunk in exhaustion.

So, the swimmer clearly doesn't "mean revert". Or does she? She actually does, but the mean reversion applies to the zig-zag, not the forward motion of the swimmer. So, the swimmer moves on towards the finish line ... the mean reversion (zig-zag) does not cause her to fall back ... just takes a little longer to get where she's headed.

It is the same with the market. The market shows mean reversion, not in the price of the market, but in the Growth Rate.

Let me give an example.

Assume the historic annual growth rate of the market is 8% and it is trading at $2,200. It goes up 14% to $2,500. Mean reversion of price would mean it would drop to $1,900 so the average price was $2,200.

However, mean reversion of the growth rate would lower future growth until that "excess" 6% is absorbed. Now, this could happen by growing 1% less (7%), for the next six years or growing only 2% the next year.

So, if growth rate mean reverts the market can go higher. It just goes higher at a slower rate to compensate for the excess growth.

THIS IS EXACTLY WHAT WE OBSERVE.

Mean reversion does NOT mean "what goes up must come down".

But, you ask, we all know the market goes up and down, isn't that mean reversion? Absolutely NOT ... in the sense it is vernacularly applied ... which is to imply the market will drop. It is the same pattern we observe in the zig-zag of the swimmer. The market mean reverts to its growth rate, not its price.

If you think about it you'll understand why there's always a bounce-back on a drop. Sometimes the bounce-back comes quickly, sometimes it's dragged out.

Significance: Yes, the market will go up and down. No one denies that. However, it will not mean revert to some previous price ... it mean reverts to a growth rate. So, we can witness an ever increasing market that is mean reverting at the same time.

Now, many will try to time the zig-zag, knowing that it is just a temporary condition. This can be done very successfully. However, those that sell or stay out of the market, expecting the price to mean revert generally find themselves losers. I know several that sold out in June 2013 when the S&P 500 hit $1,600. It was an "all time high" and surely would mean revert. Now, with the market nearly 50% higher, they are still waiting. Hope you're not one of them.

Summary: Many investors and even some professionals can be easily misled by what seems to be an accurate portrayal of market conditions. Very few actually have the training to understand the mechanics of the market. Most fall victim to "slogans" and misrepresentation.

This article illustrated how the market is systematically portrayed as being more robust than it really is ... that inflation portrayals use the same techniques to understate the true rate and that investors are wrongly influenced to sell when they should be holding or buying.

It is my hope, that through this article, I can challenge the reader to question even the most basic of "slogans" and accepted practice.

Caveat: In this article I put forth the concept that the Market has a "fundamental" growth rate around which it mean reverts. This is the current thinking amongst most statisticians and market gurus. There is a tremendous amount of scholarly articles and studies indicating this to be so.

Personally, I disagree with the "field" on this. My personal opinion is that the growth rate, itself, mean reverts around some other fundamental value or values that are not easily and currently understood.

Since I promised just a factual presentation and not a philosophical or "gut" opinion, it was beyond the scope of this article.

Courtesy of SeekingAlpha

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