"I'm up 25% on the year! Isn't that great? Who needs a professional money manager anyway? Heck, I was talking with a fee-only financial advisor the other day, asking him what he charged and how his clients were doing and he wouldn't even give me a straight answer! Guy probably can't walk and chew bubble gum at the same time let alone beat my investing returns this year!" (Individual investor speaking gives himself an air high-five and chest bumps the wall). "Baby I am hot!"
Or is he?
Academic research shows that most individual investors don't accurately track their investment returns from year to year and, on average, substantially over-estimate their returns. One study done a few years back concluded that individual investor returns were actually less than half of what individual investors thought they were - seems most folks don't actually tote up the numbers, instead relying on memory. It also seems that most folks have a very selective memory, remembering their winning investments and conveniently forgetting their losers. Or they just plain forget to back out current year contributions to their portfolio, lumping them in with their returns.
But what about the chest bumping, high-fiving dude who did do the math and was up 25% in 2009? He's kicking butt right? Well, maybe...
It turns out that measuring returns is different from measuring performance. Performance isn't just about accurately capturing a portfolio's return (although that can be difficult enough to do). It is also about measuring the amount of risk in the portfolio and making an apples to apples comparison with an unmanaged benchmark. In fact, the prestigious CFA Institute now offers The Certificate in Investment Performance Measurement (CIPM) program, which is the industry’s only designation dedicated solely to the specialized field of investment performance evaluation and presentation. The CIPM curriculum emphasizes the application of investment principles and is based on a body of knowledge defined by global best practices in investment performance evaluation and presentation. The coursework includes: Rate of Return Calculations; Benchmark Selection; Attribution Analysis; Ex Post Risk Measures; Performance Evaluation; and The GIPS Standards (don't ask, they are boringly extensive).
Okay, so on the one hand you have many individual investors shooting from the hip on their returns, with really only the vaguest notion of how their portfolio's performance compares to a comparable benchmark, and, on the other hand, you have those CIPM weenies who will put you to sleep explaining your performance and how it REALLY measures up. The individual investor and the CIPM geek might both be speaking English, but I can assure you that they are almost certainly not communicating!
And we aren't even talking about the tidal wave of emotions that pour forth when investors are talking about their nest eggs. I've gotta tell you folks that trying to have a performance discussion with an individual investor can get pretty dicey sometimes! You don't want to offend them when they proudly trot out that big return number, but you do want to find out whether that big number represents good performance or not. After all, if you made your 25% putting all of your money into a single stock, then your risk-adjusted return is gonna suck, considering that the unmanaged S&P 500 index was up about 25% on the year! (a lot less risky to buy the entire index than invest in just one stock). Conversely, making 25% in a bunch of low-beta defensive stocks means you knocked the cover off the ball in 2009. Why? Because a low-beta portfolio should lag the S&P 500 return, not match it. Here's how that works...
Any unmanaged index has a beta of one with itself, by definition. The S&P 500 goes up 10% when the S&P 500 goes up 10%. An S&P 500 stock that tends to go up only 8% when the S&P 500 goes up 10% will have a beta of 0.80. Likewise, a stock that tends to go up 12% when the S&P 500 goes up 10% has a beta of 1.2. The second stock is 50% more volatile than the first stock. Build a low-beta stock portfolio and still keep up with the S&P 500 return and you are adding value! Conversely, build a high-beta stock portfolio and merely perform in-line with the S&P 500 and, well, you are destroying value (even if you are making money) because you aren't making as much as you should. As well, you are going to lose more money than the index on the way back down with the higher beta stocks!
Bottom line here is that accurately measuring performance can be complicated. And if you can't measure your performance then it's tough to know whether you need to makes changes to your investing process.
A couple of real life examples to make the point. I recently exchanged e-mails with a friend who was initially interested in getting my thoughts on how to best hedge against the risk of inflation. I e-mailed him my two cents worth, but then encouraged him to let me buy him a cup of coffee so that we could talk more fully about the subject. I didn't want him making investment decisions based on my brief reply to his inflation concerns. He shot me back an e-mail wanting to know my fees. He also let me know that his portfolio was up 22% year-to-date (about the same as the S&P 500 at the time). Uh-oh, a tricky performance conversation looming! What to do what to do?
I mean, do I tell him that my personal all-stock portfolio is up well north of 50% on the year? Do I tell him that Biechele Royce's stock and bond portfolios are up on average 24.58% on the year, 230 basis points ahead of his (likely) all stock portfolio? Do I put him on the spot by asking him if he realizes that his return was merely in-line with the S&P 500 return and, boy, I sure hoped he wasn't loaded up with a bunch of high-beta dogs when he would've done just as well with a lot less effort (and risk) by owning an S&P 500 index fund? Tricky situation, very tricky!
Well, guess what I did do...
None of the above, because this turnip didn't fall off the truck yesterday, and I know from past experience that all three courses of action are non-starters when trying to help an individual investor understand investing results. So I ignored the performance thingy and simply reiterated that my advice was free - in fact I was going to buy HIM the coffee - and that he should give me a holler when he had some time. Epilogue: Apparently he didn't believe I was really free because I didn't hear back from him. Or maybe he didn't get back to me because I ducked the whole performance issue and he mistook my bobbing and weaving for an implicit admission that he'd outperformed us and didn't really need any advice from me...
The second real-life example involved a family member. She apparently is subscribing to a newsletter of some sort and thinks the guy is pretty good. One of his investment ideas in the first half of 2009 was a sector ETF (I think that's what she said - I was reading up on my fantasy football team and only half listening) which was up 20% since she'd bought it. Without thinking (my focus was on my fantasy football team, which was really floundering) I shot back "And how does that compare to the S&P (500)?"
Blank look from Sis as in "What the heck are you babbling about?"
So I reluctantly pulled myself away from my fantasy football team (which had sunk into second on less than spectacular play and a HUGE run by my brother's steroid using players) and made an effort to explain. Modern portfolio management is a very logical sequencing of decisions. First you decide on a strategic (long-term) asset allocation based on the clients strategic (long-term) financial goals and risk tolerance. Once the allocation decision between stocks, bonds, real estate, commodities, and cash is made (along with allocations to sub-classes such as international, emerging market, investment grade, and high-yield), the institutional investor must implement the plan. As part of the implementation process, each investment within an asset class must be benchmarked to an unmanaged index in order to determine whether active management is adding value and the active managers are earning their fees. Clearly you shouldn't be paying a manager (or newsletter author) if they aren't able to add value by outperforming an appropriate benchmark on a risk-adjusted basis. Which means in my sister-in-laws case...
Her 20% return in the sector ETF was likely top-notch if it was a utility ETF and pretty much a bust if it was a semiconductor ETF (like I said, I was distracted when she started talking so I can't honestly tell you what she had bought). But I can tell you that she didn't have the foggiest notion of how to evaluate her performance in order to evaluate her newsletter writer (they count on that by the way - make enough suggestions and a few are bound to pan out big. Point to the winners and ignore the losers and you can make most people think you're doing quite well for them!).
The bottom line here is that returns are not the same as performance and measuring performance is a complicated, yet necessary, step in deciding whether your investing strategies are really working.... or not.
Oh, and by the way, I finished second behind my big brother in my fantasy football league (having also finished second to him in 2009 in fantasy baseball!). Which means I definitely underperformed in 2009....
