Don't Bank On Statistics

photo by CarbonNYC
photo by CarbonNYC

You simply cannot rely on laws of averages when it comes to your money.

The fallacy of averages can be summed up in this example by writer Rafael Aguayo: A population of people might have an average height of 5 feet 9 inches. When you compare yourself to this average you may find you are only a little taller or a little shorter.

However if you had access to the raw data and dug a little further you might discover the population measured is actually from Africa and is made up of Pygmies and Watusi tribesmen. When you separate these two tribes or populations of data you will find the average height of the Pygmies is only 4 feet 11 inches. Statistically speaking you are probably taller than this. The average height of the Watusi’ is 6 feet 6 inches. You may not be quite this tall.

This fallacy of statistics is also found with investing. Diversification has long been held as a fundamental rule of investing. Diversifications spreads your risk across a platform of asset classes or companies.

An article in a recent addition of the Wall Street Journal by  highlighted the statistical belief that an investment portfolio of 20 stocks reduces your risk of volatility by 40%. Beyond a 40 stocks there is a diminished impact on long-term fluctuations of performance.

The WSJ also shares the efforts of Professor Don Chance. In an effort to prove the value of diversification to his students he asked 202 of them to pick a stock and calculated the inherent risk. With only one stock each you can imagine while a few were happy, overall results were poor. When a stock lost money; the whole portfolio lost money.

He then asked them to add another and another; each time calculating the riskiness of the portfolio. “On average, for the group as a whole, diversification from one stock to 20 cut the riskiness of the portfolio by roughly 40%.” Sure enough, the math played out as expected.

However, Professor Chance (what a great name for a person that teaches statistics!) analyzed the data for each individual student. He not only found examples of the average American, he also found Watusi and Pygmies; meaning many of the students did very poorly and were still exposed to a great deal of risk even after “diversification” of their portfolio. Professor Chance noted that even when stocks are picked randomly by computer, 13% of the time a basket of 20 stocks is riskier than a portfolio of one.

Ultimately the message of the article was to diversify by investing in a total market index fund with 90% to 95% of your money. Any direct investments should be limited to a hand full of stocks that you can manage to study and keep up with.

In lean management there is a core philosophy that supports this approach called Genchi Genbutsu (Japanese for go look, go see). Lean advocates see first hand what is happening on a factory floor, in your sales department or with your investments. There are just too many variables to adequately be analyzed by single report. You have to learn in person and by hand.

The message I took away from this is that when making decisions such as what to invest in; we cannot rely on what the average person is doing. We must see what is happening with our own eyes. If we invest in individual stocks, which we probably should not, we must understand the market a company is in; know who is running the organization, and what their approach to marketing is.

 

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