Average is Better!
When an individual decides to invest for their future, they immediately start hoping that their investment value starts moving up. And who wouldn’t want that? After all, appreciation of your invested amount directly implies that your decision to invest was successful. Success is good and we want to repeat them over and over again. But you must identify after each successful outcome how much of the success was out of luck and what percentage of that success belonged to your own merits.
How does one weigh in on such a decision? How can you correctly or at least objectively decide the breakdown of luck and skill in your outcome? I start with asking myself these two questions?
1) How was the competitive environment?
2) How well prepared were my competitors?
Answering these two questions will bring a fair amount of clarity with regards to the distribution between luck and skill in your outcome. It is completely possible that a successful outcome was pure luck because the competitive environment was too easy or competitors were poorly prepared.
The larger the influence of luck in producing an extreme event, the less likely the luck will repeat itself in multiple - Wikipedia
So what happens after you figure out that your outcome was nothing but a stroke of luck. Well, your future outcomes won’t turn out to be equally successful or will receive moderate success over time. This situation in mathematical terms is called regression to the mean. Everything that goes up must come down and vice versa.
In fields like investing, where luck is a real factor, some successes and failures always come down to randomness. This is also true in other phenomena, a very hot summer day followed by an average hot day. Regression to the mean is an important concept to understand because as an investor you will make both successful and unsuccessful investments and over time your results will average out.
The average is not bad. Often so happens that we are so focused on achieving above average that we tend to think that average is bad. As you can notice in the current state of the market, average returns are considered okayish if not downright terrible. Investors are looking to double their investments in a short amount of time. They are more focused on outperforming the benchmark or obtaining unreasonably high returns forgetting about the importance of focusing on their own goals. The problem with such high expectations is that it leaves no room for a better outcome than expected and plenty of space for disappointment.
Consider the story of Ford. In the 1950s, Ford had run the largest advertising campaign for their upcoming model Ford Edsel. Although many car models have failed in history. The failure of Ford Edsel Is considered being one of the most famous failures of all. In the 1950s cars were a big deal in America. Buying a car was no more considered luxurious and was attainable by the common man. People took pride in their vehicles. The landscape was changing for the auto manufacturing industry. Ford had a successful model named Ford thunderbird launched a few years earlier. Owning to this success and the changing landscape, Ford decided that their next model could be nothing but more successful. They ran a two-year-long advertising campaign on their new upcoming car model Ford Edsel. People were led to believe that the car would be the best available in the industry. Their expectations from the car were hyped up so much that when the actual car was revealed, people realized that it was nothing but just a car and not a particularly attractive one either. The expectation bubble was popped and the sale of the car was nowhere near the expected numbers.
So what led Ford to this disastrous outcome?
The part of the problem was the hype and the expectation ford had created over their marketing campaign. With such high expectations set among people, it could only fall short of the deliverance. Following this outcome, ford had experienced nothing but a return to their mean. The History of ford produced cars in the 90s go like
Ford Thunderbird - A Hit
Ford Edsal - A Flop
Ford Mustang - A Hit again
Our environment sometimes, makes us forget that average returns and average outcomes are bad. Instead of focusing on achieving outliers with each decision, rather focusing on improving our average over the long term will have better outcomes in our portfolio and other decisions.
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Until next time….