Averages are used by Sub-Average Minds...

Averages are best hiding tools for incompetents.... 
O Ashuji...

Markets have historically traded at average P/E of 16x....

Markets have historically given 15% annual average return...

GDP grew at an average of 9% per annum during last 5 years after we got elected...

Average per capita income of our country is USD 30000....

Average Inflation rate for last 20 years is 5%....

Historically average interest rates have been 4% on 30 year mortgage...

How often have we heard these statements from Policy makers, Economists, Central bankers and Fund Managers...?? These are absolutely meaningless statements and are often used by these people as guiding posts....Average hides the true picture and is often used by sub-average people because they want to put everything in one number. When such averages are used to depict reality, it can be very misleading. While when same averages are used as guiding post, it can be disastrous.

Let Examples Talk....

1) Fund Managers/Analysts talking about historical average P/Es....
Many a times we hear about historical P/Es being used to justify a buy or sell for a stock by Fund managers/Analysts. Time frame for historical P/E being used is based on convenience. P/E might have range of 10-40x and yet these guys arrive on an average to make useless recommendations. Averages are used purely as justifications with no usefulness mathematically.

Concept of Average P/Es....

1) Let say an Analyst recommends a stock based on historical average P/E. Year 3 has historical average of 20x while one year forward P/E then is 23x. Analyst might put a sell based on historical average.

2) Year 4 stock actually goes up by 60% both due to P/E expansion and earnings growth. Now Analyst will spin new stories and fundamentals have changed kind of reasoning. He might assign higher "historical" P/E in year 4 and put a buy on the stock only to see stock fall by 40% in subsequent year.

3) Now average P/E for all 5 years is 24x and company is having decent growth of 20% in earnings, yet stock wildly fluctuates and so does P/E. Average concept is absolutely meaningless due to wide dispersion in P/E itself. One can construct such example for longer time frame but conclusion will still be same. If P/E doesn't have wide dispersion then target prices will be close to earnings growth and analysts are absolutely poor in forecasting earnings growth. Basically using average P/E to put across a point is result of dumb mind.

2) Fund Managers/Analysts talking about average historical return of stock markets...
Just like average P/E, many a times we hear from these experts about average historical return from stock market. Long term returns will be talked about to influence investors to put their money into stock market. These averages are used just to sell their stories/products.

Hypothetical Stock Market Returns over 20 years....

1) A lazy fund manager might say stock market over 20 years have given average annual return of 15%. This 20 year had 2 notable 5 year cycles...11-15 ---smooth trending cycle and 16-20 highly volatile cycle. Yearly returns over this 20 year period ranged from -70% to 100%.  Average would have been meaningless concept for investor entering in year 16 or year 20.

2) Similarly a fund manager trying to sell alternative investments (other than equity) might pick up pick up 6-10 year cycle and say average return for equities over last 5 years has been -5%.

Thus concept of average is absolutely arbitrarily used with no respect to dispersion within sample data or time frame used. 

3) Government talking about average inflation, interest rates, GDP growth, etc

When averages are used as guiding posts by Policy makers, Central Bankers,Economists/Analysts, outcome can be disastrous and Volatility is given. Lets understand this point through current example...

Reserve Bank of India (RBI) striving for historical average inflation of 5%...

Historical anchoring is typically derived from recent history and recent history can be very different from current reality....O Ashuji

RBI has been targeting CPI inflation of 5% since last 2-3 years and has been tightening to achieve that goal...

India's Consumer Price Inflation

1) Average Inflation has been widely fluctuating since 1994.

2) 1999-2007 had least dispersion in inflation data and this was also time when term like great moderation was coined because whole world was experiencing great disinflation for all known reasons. 

3) Anchoring average inflation of 5.7% during 2004-2008 could be misleading because each cycle is different. Current cycle could be very different than previous one. Government policies could be the reason for inflation rather than credit driven inflation. 

4) Fall in inflation during 1999-2008 would have nothing to do with monetary policy, yet those averages are used as anchor to guide current situation. 






When machine as complex as economy is guided through policies driven by averages, volatility will persist and cycles will get shorter and violent.