We use averages a lot in the business of investing and financial planning. Two of the most common ways we rely on averages is when we discuss a historical track record and when we make projections for the future. These are often necessary to do as part of our business. However, without a deep understanding of biases, in particular the anchoring effect, using averages incorrectly may be part of the reason investors do so poorly.
How Averages Mislead Us
Averages mask volatility. When quoting an average we are smoothing out all the fluctuations that made that average. And the way our brains work, if we are to picture an average of 6%, we are more likely picture an upward sloping line than an EKG printout.
In a recent WSJ article, it was reported that the market has historically stumbled in February, August and September. The month of October? It averages +1.0%. That may very well be true, but how did an investment in October work out for investors in 1987 and 2008?
What’s Your Anchor?
This is not a call to abolish the reporting of averages; they are needed. Rather it is to understand that providing an average, without the proper context, can mislead and even influence investors to make poor decisions thanks to the anchoring bias.
The anchoring bias is where our brain, unconsciously, seeks a reference or starting point when guessing an answer. We use whatever figure is top of mind and then make minor adjustments to it. The anchor does not have to be related to the question at hand – anything will suffice. When we report averages, we are giving investors the anchor to use.
Using Averages Correctly
Whenever we use any average, we must assume the investor is going to anchor and then expect the average to happen going forward. If the investor anticipates earning an average of 6% per year, they are going to expect 6% per year, on average. If we have a quarter where the market is down 20%, that will shock them and may result in making a costly decision.
When we provide averages, we should also clearly explain the range of returns investors are likely to experience along the path to achieve that long-term average return. In that way, you provide them with the correct anchors.
There is no Holy Grail to helping people stay the course when investing. But understanding how the brain works, how averages act as anchors and begin to provide correct anchors for clients can certainly help.