Long term average: Meaning, Criticisms & Real-World Uses

What Is Long Term Average?

A long term average in finance refers to the mean value of a financial metric or economic indicator calculated over an extended period, typically spanning several years, decades, or even longer. This concept is fundamental to quantitative analysis and financial metrics, providing a smoothed perspective that filters out short-term fluctuations and noise. Investors and analysts use the long term average to understand the typical behavior and underlying trends of assets, markets, or economic variables, offering a benchmark against which current performance can be evaluated. It is a critical tool for strategic planning, especially when considering investment horizons that span many years, as it helps temper expectations derived from recent performance with historical context. Understanding the long term average of various financial series is essential for sound financial decision-making and developing robust asset allocation strategies.

History and Origin

The practice of calculating and analyzing long term averages in economic and financial contexts emerged alongside the systematic collection of historical data. Early economists and statisticians began compiling long series of data to identify patterns in phenomena like economic growth, commodity prices, and interest rates. The formalization of these concepts gained prominence with the development of modern economics and statistics in the late 19th and early 20th centuries. Institutions like the National Bureau of Economic Research (NBER), founded in 1920, became instrumental in systematically identifying and dating U.S. business cycles, which inherently relies on analyzing long-term trends in various economic indicators to determine periods of expansion and recession. The NBER's Business Cycle Dating Committee, for example, analyzes a range of economy-wide measures, including real personal income and nonfarm payroll employment, over extended periods to establish its chronology of peaks and troughs.⁶

Key Takeaways

A long term average provides a smoothed view of financial data over extended periods, reducing the impact of short-term volatility.
It serves as a historical benchmark for evaluating current performance and setting realistic expectations for future returns.
The calculation involves summing values over a defined long period and dividing by the number of observations.
Despite its utility, a long term average can be misleading if underlying market conditions or economic structures have fundamentally changed.
It is widely applied in investment planning, risk assessment, and economic forecasting.

Formula and Calculation

The long term average is typically calculated as an arithmetic mean, which involves summing all observations over a specified long period and dividing by the total number of observations.

The formula for the arithmetic mean (average) is:

\text{Long Term Average} = \frac{\sum_{i=1}^{n} X_i}{n}

Where:

( \sum_{i=1}^{n} X_i ) represents the sum of all individual data points ( X_i ) over the period.
( n ) is the total number of observations or periods in the dataset.

For instance, to calculate the long term average annual return of a stock index, one would sum the annual returns over several decades and divide by the number of years. This simple calculation provides a measure of the central tendency of the data, offering insights into the typical performance over the chosen investment horizons.

Interpreting the Long Term Average

Interpreting the long term average involves understanding that it represents a historical tendency rather than a guarantee of future outcomes. For investors, a long term average of, say, market returns, can offer a foundational expectation for nominal return or real return after accounting for inflation. For example, the S&P 500 has delivered a long term average annual return of approximately 10.50% including dividends.⁵ This figure is often cited as the expected return for broad market investments over extended periods.

However, a single long term average value does not convey the full picture of past performance, which often includes significant periods of deviation, extreme highs, and lows. It is a statistical summary that smooths out the peaks and troughs of market volatility. When assessing current conditions, analysts compare recent data to the long term average to identify whether the present environment is above, below, or in line with historical norms. A deviation from the long term average might suggest a market correction is due, or it could indicate a new underlying trend emerging.

Hypothetical Example

Consider an investor analyzing the hypothetical long term average annual return of a diversified portfolio. Let's assume the portfolio's annual returns over the past 20 years were:

Year 1: 15%
Year 2: 10%
Year 3: -5%
Year 4: 20%
Year 5: 8%
... (and so on for 20 years, with varying returns)
Year 20: 12%

To find the long term average annual return, the investor would sum all 20 annual returns and divide by 20.

If the sum of these 20 annual returns is 200%, then the long term average annual return would be:

\frac{200\%}{20} = 10\%

This 10% figure represents the hypothetical long term average annual growth rate of the portfolio over that specific two-decade period. While this average provides a simple benchmark, it's crucial for the investor to remember that individual years can diverge significantly from this average, highlighting the importance of risk management and a long-term perspective.

Practical Applications

The long term average is a widely used metric across various facets of finance and economics. In investment management, it informs assumptions for financial forecasting and retirement planning. Financial advisors often use historical long term average returns of asset classes, such as stocks and bonds, to project potential future portfolio values, although they always caution that past performance is not indicative of future results. For instance, the historical long term average return of the S&P 500 is a key data point for long-term equity investors.⁴

In economic analysis, the long term average is used to understand the typical growth rates of Gross Domestic Product (GDP), inflation, and interest rates. For example, the Federal Reserve Bank of St. Louis's FRED database provides access to long-term historical data for various interest rates, such as the 10-Year Treasury Constant Maturity Rate, which allows for the calculation and analysis of its long term average.³ Such averages help policymakers assess the health of the economy and guide monetary policy decisions.

Furthermore, in capital markets, the long term average of factors like valuation multiples (e.g., price-to-earnings ratios) can provide context for whether the market is currently overvalued or undervalued relative to its historical norms. Corporate finance professionals might use the long term average cost of capital or return on equity to evaluate project feasibility or company performance over time. This approach helps in understanding the persistent underlying trends that drive economic and financial systems.

Limitations and Criticisms

While highly useful, the long term average has several important limitations. One primary criticism is that "past performance is not indicative of future results." Relying solely on a long term average can create a false sense of certainty, as future economic and market conditions may differ significantly from those in the past. Structural changes in the economy, technological advancements, regulatory shifts, or unforeseen global events can render historical averages less relevant. As one analysis notes, the "world is different than it used to be" regarding financial, regulatory, and tax landscapes, making a direct application of old averages potentially misleading.²

Another limitation is that a simple long term average does not account for the sequence of returns, which is crucial for investors, particularly those near or in retirement. Two periods with the same long term average return can yield vastly different outcomes if the negative returns occur early in one sequence and positive returns occur early in another. This phenomenon is related to the impact of compounding. Additionally, extreme outliers within the long historical period can skew the average, making it less representative of typical performance. Metrics like standard deviation and other measures of dispersion are necessary to provide a more complete picture of the data's variability. Moreover, historical data may contain biases or errors, and evolving market dynamics may not be fully captured by historical analysis.¹

Long Term Average vs. Short-Term Volatility

The long term average and short-term volatility represent two distinct but complementary aspects of financial data analysis. The long term average provides a smoothed, overarching view of an asset's or market's typical performance over an extended duration, abstracting from the immediate ups and downs. It aims to capture the underlying trend and central tendency, offering a historical benchmark for expected returns over lengthy investment horizons.

In contrast, short-term volatility measures the degree of fluctuation or dispersion of an asset's price or return over brief periods, such as days, weeks, or months. It quantifies the unpredictability and rapid changes in market value, reflecting the immediate reactions to news, sentiment, and liquidity dynamics. While the long term average helps set broad expectations for growth, short-term volatility highlights the risks and potential for rapid gains or losses within shorter timeframes. Investors often seek to balance the long-term growth potential indicated by historical averages with the near-term risks implied by high volatility when constructing a diversified portfolio.

FAQs

What is considered "long term" in finance?

The definition of "long term" can vary depending on the context, but generally, it refers to periods of five years or more. For investment planning and economic analysis, "long term" often extends to 10, 20, or even 50+ years, covering multiple business cycles and market phases.

Why is the long term average important for investors?

The long term average helps investors set realistic expectations for returns, understand the historical performance of asset classes, and make informed decisions about asset allocation. It provides a stable benchmark that helps temper reactions to short-term market fluctuations and encourages a disciplined approach to diversification.

Can the long term average predict future performance?

No, the long term average is a historical measure and does not guarantee or predict future performance. It offers insight into past trends and behaviors but cannot account for unforeseen future events, changes in market structures, or fundamental shifts in economic conditions. While useful for context, it must be used alongside forward-looking analysis and sound risk management principles.

How does inflation affect the interpretation of a long term average?

Inflation erodes purchasing power over time. Therefore, it's crucial to distinguish between a nominal long term average (before inflation) and a real return long term average (after adjusting for inflation). The real return average provides a more accurate picture of the actual increase in purchasing power an investor would have experienced over the long term.