Reframing Performance with Better Charts
Most people rely on the mountain chart, a line or area chart which shows the growth of an investment over time, as a basis for evaluating performance. This type of presentation, which emphasizes volatility, timing, and emotionally charged events like 2008 has inherent biases that distort how we view performance and obscures the real long-term probability of a successful outcome.
A better approach to viewing performance is as a return distribution chart. For example, charted here is the distribution of the 89 annual S&P 500 returns from 1928 through 2016. It is clear from this presentation that there are far more positive years (everything to the right of the yellow bars) than negative years, with a positive return 73% of the time. The most likely annual return over this period was between 10% and 20%, occurring 20 times, or about 1 out of every 5 years. These types of helpful observations are difficult if not impossible to obtain using the typical mountain chart.
S&P 500 INDEX CALENDAR YEAR RETURNS (January 1, 1928 – December 31, 2016) | Open in full screen
Source: S&P Dow Jones Indices LLC
Also, noteworthy is how the large positive returns exceed the large negative turns. This latter observation may come as a surprise to many, as large negative returns are emotionally seared into our memory, while comparably sized positive returns are often forgotten or overlooked.
Examining a distribution chart of performance clearly demonstrates that the stock market favors long-term investors. Discussing the market in this way provides valuable long-term perspective. Reframing performance discussion in terms of probabilities helps to avoid some of the pitfalls associated with the mountain chart and is less likely to trigger strong emotional reactions, which when associated with certain events, can result in poor decisions and erroneous conclusions.
From the Behavioral Viewpoint
What is going on?
- We are easily Fooled by Randomness. We have a hard time accepting randomness and have a strong desire to make sense of things. We use patterns, stories and shortcuts to help understand what is going on around us, even if it means making up a story or plausible theory.
- Stories help us understand and interpret the world around us and provide a frame of reference that we can remember. This Narrative Fallacy, a natural overemphasis on narrative over data, typically results in faulty analysis. Mountain charts further encourage this faulty analysis as stories get created around random events tied to emotional experiences and peak memories.
- We also suffer from the Law of Small Numbers. Believing that we have a unique insight from a brief glance at a chart and our own experiences, we extrapolate based on a small amount of information and our inherently biased perspective.
What can we do?
- Learn to understand performance in terms of return distributions. Develop realistic expectations and accept that both positive and negative returns will inevitably occur. Recognize that the time frame necessary to achieve objectives often requires significant patience. Ultimately, the more draws from the distribution, the better the outcome.
- Use a needs-based planning approach to separate out short and long-term needs. Give resources allocated to long-term growth sufficient time to achieve their goals. Creating and following a well-developed investment process can provide critical discipline. Like many other areas in life, planning beforehand can lead to better results.
- Work with a professional financial advisor who has relevant education and experience. He or she can provide an independent perspective and act as a trusted resource and behavioral coach.
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IMPORTANT INFORMATION AND DISCLOSURES
The information provided here is for general informational purposes only and should not be considered an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. It should not be assumed that recommendations of AthenaInvest made herein or in the future will be profitable or will equal the past performance records of any AthenaInvest investment strategy or product. There can be no assurance that future recommendations will achieve comparable results. The author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions. AthenaInvest disclaims any responsibility to update such views. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of AthenaInvest.
You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives financial circumstances. You should consult with a qualified financial adviser, legal or tax professional regarding your specific situation. Investments involve risk and unless otherwise stated, are not guaranteed. Past Performance is no guarantee of future results.