Have a great weekend!

I was going through Dale Carnegie’s book notes and came across this advice from Willis Carrier for dealing with worry:

**Step I.** Analyze the situation fearlessly and honestly and figure out what is the worst that could possibly happen as a result of this failure.

**Step II.** After figuring out what is the worst that could possibly happen, reconcile yourself to accepting it, if necessary.

**Step III.** From that time on, calmly devote your time and energy to trying to improve upon the worst which you have already accepted mentally.

If you haven’t read Dale Carnegie’s two classics “How to Win Friends & Influence People” and “How to Stop Worrying and Start Living”, I highly recommend them. Great stuff.

I came across an article last night that stated that the average annual return for the S&P 500 was 12% from 1926-2014.

The way this author arrived at 12% was to add up all the yearly returns over the last 89 years and divide them by 89. When I do that with my numbers, I get 11.99%. Going further, using that return, $100 invested at the beginning of 1926 would have grown to nearly $2.4 million by the end of 2014. The math looks like this:

^{89}

Unfortunately, that’s not reality. Let me try to explain it with a simple example.

Say an investor received the following returns over three years:

Year 1: 25%

Year 2: -50%

Year 3: 25%

The average of those three years would be 0%. Now let’s calculate how it would have looked had we invested $100 at the beginning of the first year and held it through year three:

Year 1: $125.00 ($100 + ($100 x .25)) OR $100 X (1 + .25)

Year 2: $62.50 ($125 + ($125 X -.50)) OR $125 X (1 – .50)

Year 3: $78.13 ($62.50 + ($62.50 x .25)) OR $62.50 x (1 + .25)

**ONE QUICK NOTE:** Some people have a difficult time with math and since this is a “Basics” post, I’ll spend a little extra time talking about how to think about returns. The reason we add 1 to return expressed as a decimal (1 + .25) is because 1 represents the original investment. So, we are getting our $100 back plus $25. When we have a negative return, we subtract the negative return from 1 (1 – .50) because we are losing part of our original investment. In this case we are losing half of our $125. Does that make sense?

Based on the average return we calculated earlier, the $100 should have been worth $100 at the end of the third year because our numbers showed a 0% return, but this shows that our $100 investment is only worth $78.13 (a 21.88% loss). What accounts for the difference?

The difference is the first average used was simply the arithmetic mean (average) and doesn’t take into account an actual investment. To find out our actual return, we need to use something called the geometric mean (average). To do that, we need to change our formula up a bit. First, we need to express the returns as multipliers by adding 1 to them. Like this:

Year 1: 1.25

Year 2: 0.50

Year 3: 1.25

Now, we simply multiply those factors together and raise them to the power of 1/3 (or find the 3rd root). Like this:

^{1/3}

^{.3333}

Now, in order to get this to a percentage, we have to subtract 1 from .921008, which leaves us with -.07899 or -7.899%.

We can check our answer by plugging our finding back into the following equation:

^{3}

IT WORKS!

So…

Back to the opening paragraph, which stated that the average return from the S&P 500 Index was 12% from 1926-2014. The geometric average is 10.04%. “Not much different,” you might think. The difference is huge when we are talking about 89 years. Let me show you:

^{89}

That’s nearly $1.9 MILLION less than the number we get using the average return. Which brings up an important question: why do people still talk about averages?

Extra credit: Here are a couple of useful YouTube videos I found that talk about the geometric average (or mean)…

Here’s something for Throwback Thursday…

The Dow Jones Industrial Average had a closing peak in 1987 of 2,722 on August 25. It didn’t close that high again until nearly two years later on August 24, 1989. I was just a kid back then. I graduated from high school in 1988 and although I was into the stock market and business, I didn’t realize that it took that long for it to get back to 2,700.

I can sum up August 2015’s market performance for you in one word:

NASTY!

In the eight indexes I follow (plus crude and oil), only two were up during August: crude oil and gold.

The S&P 500 Index—the index I follow most closely and have the most data on—was down 6.03%. That was its worst August performance since 2002.

Year-to-date, everything is down except the Barclay’s Aggregate Bond Index.

You can see the results for yourself by downloading the latest PDF: S&P 500, MidCap 400, SmallCap 600, & 1500 Performance History (01-2011 – 08-2015)

Dan Price, CEO of Gravity Payments, made waves when he announced back in April that his company would pay their employees a minimum of $70,000 per year phased in over two years.

The press was giddy. The DailyKos was happy.

Dan’s smiling face was all over the place (a PR stunt?)

Fast forward just a couple of months…

Gravity Payments is having troubles. Severe troubles. Some clients, fearing price increases, decided to leave. And then there was Gravity’s own employees…

…some of the most valuable employees at Gravity Payments have started to leave the company. The Times reported that two employees have left directly because of the policy. One told the paper she was initially excited about the new policy, but as she thought about the details she began to get dismayed. “He gave raises to people who have the least skills and are the least equipped to do the job, and the ones who were taking on the most didn’t get much of a bump.”

She said she presented the issue to Price along with an alternative way to raise salaries, but was met with an accusation of selfishness. So she decided to quit. Another employee, on the lower-end of the former pay range, also decided to quit after thinking through the policy. “Now the people who were just clocking in and out were making the same as me,” he told the Times. “It shackles high performers to less motivated team members.” (Source)

Bottom line: people want to be rewarded for their efforts. They want to be appreciated.

Now, some might think I’m just a tad too happy to see this company experience failure. I’m not. BUT…I am happy to see that dumb (or shortsighted) decisions have bad consequences. Had Mr. Price only thought through his decision, he might have saved himself and his company a lot of pain. I would suggest Mr. Price invest in a copy of Thomas Sowell’s Basic Economics*, which does a nice job explaining how the real world works.

Ironically, the DailyKos hasn’t followed up on the story since their original post back in April. I know, I know…it doesn’t fit their narrative.

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