A boat has sunk in the middle of a river. Jack and Jill, both 6 feet tall are forced to wade through the water to reach land. They see 2 sign boards in opposite directions. Sign A says ‘average depth 5 feet’ and sign B says ‘average depth 3 feet’. Jack follows sign A while Jill follows sign B. One of them drowned; can you guess who it was? It was Jill unfortunately. This is where the problem of averages comes in.
The average depth of water on the path Jack followed remained more or less constant (less volatile). Jill on the other hand was in that part of the river that would suddenly become 9 feet deep at times and would be 1 foot deep at other times. It was very uncertain (highly volatile). This led to him drowning.
Similarly the problem of averages arises in investments as well:
Take two funds A and B for example. Fund A gives a return of 14% while B gives a return of 15% on an average. Majority of investors would prefer fund B simply due to the 1% higher return. But when one compares the year on year return, fund A is less volatile i.e it gives consistent return over a long term. While fund B on the other hand could give huge negative returns in 1 year and give the completely opposite positive returns next year. The difference between year on year return would be very large and unpredictable (highly volatile).
Thinking Man Advice:
- While investing in a fund don’t blindly look at averages as that doesn’t consider how volatile the fund has been.
- Take a risk profiling to identify your appetite for volatility.