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Skewness

VERY FEW INVESTORS put a big chunk of their portfolio in Amazon or Apple 20 years ago and then held on—and yet such huge winners heavily skew our view of stock market investing. Because we can easily recall these gangbuster stocks, we imagine that picking stocks like these is not only easy, but also the key to investment success. This is the psychological phenomenon known as availability bias.

But it’s also a statistician phenomenon. Every year, the stock market averages are driven higher by a minority of stocks with huge gains. These big winners often receive heaps of publicity, making it seem easy to beat the market. But in truth, just the opposite is true: Because these big winners drive the market averages higher, a majority of stocks end up trailing the averages. Result: If you pick just one or two stocks, the odds are you’ll lag behind the market averages—which is why broad diversification, especially through low-cost total market index funds, is such a smart strategy.

Skewness doesn’t just distort our view of the stock market. It also shows up in a host of other numbers crucial to our financial life. Consider life expectancies. Suppose you’re age 65 and you’re trying to get a sense for how long you need to make your nest egg last. If you look at life expectancies as of birth, you might imagine you won’t live beyond your mid-70s. Problem is, such statistics are skewed lower by the unlucky individuals who die before they reach retirement age.

Instead, to get a handle on your retirement’s likely length, you should look at life expectancy as of age 65. Such estimates indicate you’ll likely live until your mid-80s. But even these estimates should be treated cautiously—because they’re averages and half of all 65-year-olds will live longer than average.

Skewness also influences data on wealth and annual incomes. Take the Federal Reserve’s Survey of Consumer Finances. If you add up the wealth of all families and then divide by the number of families, you find that the U.S. average (or mean) household net worth is $692,000. But if, instead, you look at the typical (or median) net worth—that of families halfway down the list from richest to poorest—you find it’s just $97,300. Why? In the case of the mean, it’s skewed higher by the small number of households with enormous wealth.

Such outliers also influence other data, such as average health care spending or average spending on nursing home costs. To be sure, we might end up being one of the outliers, so we need to be financially prepared. But such averages aren’t a good guide to the experience of the typical American.

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