The information overload for financial and investment issues presents a daunting obstacle. Conflicting opinions, short-term strategies, lack of context, self-serving recommendations, arcane terminology – it is confusing at best and dangerous to financial health at worst. The endless stream of numbers that is casually added to the mix certainly doesn’t help. Here are some ways to avoid misinterpreting numbers and to use them to your advantage.
Reference points – The most dangerous emotions in investing – fear and greed – are often triggered by reports of “15% off its high” or “biggest increase in six years”, accompanied by descriptions such as “plummeting” or “soaring”. These reports alone can send investors running for the exits or lining up to invest their money. (In fairness to the media, their diverse audience forces them to use some generic reference point.)
But those reference points of a high or low, or some arbitrary time frame, usually have no direct connection to an investor’s specific experience. If an investment has been held for a long period, even a sharp short-term drop probably leaves the investor with a sizable gain. Fortunately, many financial firms now provide gain/loss information and some retirement plan providers offer a personalized rate of return, and these are far more useful to individual decision-making.
Information or knowledge– A classic Dilbert cartoon has the pointy-haired manager complaining that 40% of days off are taken on Mondays and Fridays, and that trend must be investigated. He is simply reacting to 40% being a large number, so it must be bad.
Understanding the necessary context of raw data or snippets of information can convert them into useful knowledge, and knowledge is power. Having a perspective for broad markets, long-term trends, the size of the universe being described or what the typical or expected measure should be can provide context and prevent impulsive and costly mistakes. (Here’s the context: Mondays and Fridays are 40% of the workdays, so the days off are in proportion to the rest of the week.)
What goes up – That all markets and investments have up and down cycles is proven to be true over and over. A corollary to this law is “regression to the mean”, which holds that an investment that has outperformed its peers is destined to return to average returns over time. For example, less than 20% of top-performing mutual funds in three- and five-year periods are above average in the following period.
The real danger is that there is a lag between the time an investment begins its strong performance and the time it is recognized by the general investing public. Worse yet, it can be two years before the public is convinced the performance is for real, and as luck would have it, periods of outperformance tend to lose steam between years two and three. In other words, investors who chase performance end up buying an investment just when it hits its peak, and those same performance chasers are inclined to sell an investment just as it has hit its bottom and chase the next strong performer. Buy high, sell low is not a successful strategy.
Time is on your side – The convenient omission of a time frame when presenting results is an easy, and often misleading, way to get attention. Without the corresponding time frame, results cannot be evaluated against other investment choices, and because of the magic of compounding huge long-term returns may actually mean mediocre annual returns. For example, an investment that increases 7% annually will actually double in value in just over ten years.
Remember the old school “rule of 72” to make a quick evaluation. Simply divide 72 by the annual return to determine the years needed for the value to double, or divide 72 by the years needed for the value to double to determine the annual return. With a little practice you can use the rule to translate all sorts of returns and time frames into the information you need.
We’re number 1 – Although not as prevalent as in the past, performance advertising still goes to great lengths to portray a fund as number one in some category or over some time frame. But that ranking is often so specific to that fund that is has no comparative value to other funds or to making an informed investment decision. A fund’s short-term ranking is far less important than its long-term performance and consistency, neither of which make for splashy ads.
What’s my yield – Yield, or the income generated by an investment as a percentage of its cost, is frequently confused and interchanged with total return, which is yield plus capital appreciation, or the increase in price. Some investments, such as money market funds or certificates of deposit, offer only income, while other investments such as bonds, stocks and real estate have a combination of income and capital appreciation in varying degrees. The real danger in confusing the terms is that investments with higher income yields tend to offer less possibility for price appreciation, so looking only at yield could inadvertently result in too conservative a portfolio. Likewise, looking only at price appreciation could lead to a risky portfolio.
Comparing total returns is probably the best choice, but only if there is also some method to evaluate risk; higher return investments will always involve more risk. There are plenty of statistical measures for risk, or you can simply review a list of quarterly returns or a chart that includes multiple investments over time.
The best defense to getting trapped by numbers is to first identify financial goals and a broad strategy to reach those goals. Numbers then become tools to implement and evaluate that strategy rather than a never-ending collection of random changes. For example, confirm whether the reasons and circumstances for owning (or not owning) an investment have changed before relying on numbers. This will avoid decisions made in haste and lead to a more consistent portfolio and, perhaps, a bit less anxiety.