Good, Bad or Ugly: The Challenge of Assessing Performance

Good, Bad or Ugly: The Challenge of Assessing Performance

The bottom line up front: Nobody knows anything.

The smartest people who work in the motion picture industry do not know for certain what’s going to be a hit or a flop. “Every time out it’s a guess and, if you’re lucky, an educated one,” wrote William Goldman in “Adventures in the Screen Trade.” The same could be said of the investment industry as this recent article in “The Economist” explained. Once you accept this basic concept about investing, you can earn much higher after-tax returns than the vast majority of investors.

Understanding performance is a challenge for clients, and advisors often don’t do a very good job of reporting it. Performance can be difficult to meaningfully measure because of its complexity, its dependence on context, and because tools are limited. Some investors are obsessed with “beating the market” but most, at least in my experience, are more interested in achieving their financial objectives.

Some typical ways to measure performance:

  • Comparing to a blended benchmark:  An interesting comparison, but less relevant if asset class weightings are optimized. After-tax returns won’t show, and risk is not factored in. Better to compare your returns to those of a world stock and bond index that matches your risk profile as this will help you see how your asset mix is doing.
  • Risk-adjusted return:  This will tell you how you did relative to the risk you took, but there are many ways to measure this and it doesn’t necessarily relate to your goals. The Sharpe Ratio is one of the better measures.
  • The S&P 500 or Dow:  These indices are the most popular benchmarks against which to judge performance. Unfortunately, comparing them to your portfolio is comparing apples to oranges.
  • After-tax return: This tells you how tax efficient your portfolio is, which advisors have a lot of control over. But, there are limited tools to easily report it.

 

Give it time:

The best way to evaluate performance is over an economic cycle, which includes expansion, maturity, recession, and recovery. Evaluating performance over just one part of the economic cycle matters, but it can lead to performance chasing or making premature changes.

It’s important to know why you are underperforming or outperforming, but it’s usually a bad idea to try to “do something about it.”  Studies show that the more investors make changes, the more performance declines.

Give it at least five years, more if you can. The key is whether your returns are getting you closer to your goals. If your required real return to meet all your goals (after inflation) is 3%, perhaps that is the best measure, especially if you don’t want to lose the sleep a higher return might cost you. Determine your cash flow needs to define your required return.

Context matters:

When outperforming, especially relative to S&P 500, investors often ignore context. For instance, the broad index did significantly better than most asset classes in 2013 and 2014, but it underperformed a diversified multi-asset class mix considerably – with more risk – during the 2000 to 2014 time period. Thus, you could have outperformed the S&P 500 during that time period but still performed badly.

Contrary to popular opinion, it is during trailing periods and bear markets when good advisors earn their fees. For example, emerging markets are currently unappealing to investors despite having the highest growth potential and a cheap valuation.  Good advisors don’t let short-term performance pressure influence their allocations, and they know trying to time the market is a fool’s errand.

Managing outperformance:

If your portfolio is outperforming, take time to understand why, and how much risk you’re taking to achieve those gains.  Often, you can be tempted to put more money into an outperforming asset class or manager, but it’s usually best not to, as today’s winners are usually tomorrow’s losers.  This is when simple rebalancing makes a significant impact, forcing you to sell your winners and buy more losers.

Riding out underperformance:

If your portfolio is underperforming, the best thing you can do might be to wait. The best investors, including Warren Buffett, have underperformed at least four years in a row over their investing careers. If you can accept that we’re all making educated guesses, you can tune out the noise and make better decisions.

 

Ben Johnson
ben@highlandprivate.com
No Comments

Sorry, the comment form is closed at this time.