When prospective clients meet with us to evaluate their portfolio, many investors are unaware if their portfolio is experiencing sub-par performance relevent to the appropriate benchmarks. Here’s what to look for when you’re evaluating your investments’ performance.
Ignorance is bliss. When it comes to investment performance, there’s a ring of truth to this old adage. It’s not difficult to see how active managers – investment professionals who attempt to “beat the market” in search of greater returns – can be driven by self-interest to ignore feedback and continue along the same (quantifiably sub-par) path.
The real question: Why do investors tolerate this underperformance?
The (partial) answer? You have to be aware of sub-par performance before you can get concerned about it – and most investors don’t know how to measure or evaluate performance.
When is an Investment Management Solution Actually a Problem?
Investors are not to blame for their lack of information because:
The complexities of the investment world make it difficult to obtain a clear picture of performance
The financial media and investment firms themselves generate a huge amount of mis/information that’s designed to obfuscate reality and distract investors’ attention
It’s in active managers’ best interests to keep investors in the dark
In fact, if investors had all the facts and were provided with accurate feedback, it would be a lot harder for poor-performing market-beating efforts to continue.
Consider this: Do you know the compound annualized rate of return on your investments? Probably not, especially if you own mutual funds or manage your own portfolio, because the calculations aren’t easy. You’ve likely made investments, additions and change at various times, all without calculating performance at regular intervals. To do these calculations, you either need to be a serious math wonk or have access to specialized financial software.
Making Well-Calibrated Investment Planning Decisions
Then there’s that whole “predicting the future” thing. According to researchers Daniel Kahneman and Mark Riepe, a “well-calibrated” decision-maker as one who doesn’t make systematic prediction errors.
Thus far, exactly two groups have been found to be well-calibrated: meteorologists and race-track handicappers. Why? Because they:
Face similar problems every day
Make explicitly probabilistic predictions
Obtain swift and precise feedback on outcomes
When these conditions aren’t satisfied – as they aren’t in the markets -- expect overconfidence.
Don't Base Your Financial Strategies on Slight of Hand
Thanks to this overconfidence – mixed with the widespread dissemination of misinformation and the financial media’s collusion -- a investment professional's picks may appear to perform well... even when their relative performance is poor.
Evidence indicates that active management hinders, rather than enhances, performance. So why does this negative impact generally go unnoticed? One of the main culprits: Using inappropriate benchmarks to measure performance.
When you’re working with irregular time periods, determining the right benchmark is difficult. Say you made an investment in June, 2004 and you want to see how you’re doing in December, 2013. How do you determine the correct benchmark numbers for that period?
Another culprit: Confusing positive returns with excess returns. Say you have an 11% ROR over eight years. Sounds pretty good, right? Well… you may have achieved 11%, but you were invested in an asset class that achieved 15%. Your personal financial advisor actually retarded your performance by 4%.
Keep in mind that everything is relative, a fact that your wealth advisor should be well aware of. Arming yourself with the correct information will help you make more accurate assessments of your investments’ performance.