Benchmarking Investment Performance

Investment Perspective – October 2017

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

There are a variety of measures used across the markets. 

Commonly, individual investors often compare the bank interest rate with the increase or decrease in the cash up value of their investment portfolio. 

If the bank interest rate is 3.5% and their investment portfolio grows by 2%, they argue that by the time they have paid fees, they may as well have been in the bank – indeed, they would be better off over that period of time.  The thinking behind this is more about the emotion of uncertainty around management, skill and the concern that last year’s result is an indication or a guarantee of future results – all bad! 

Others, who may be a bit more academic about it, might compare a share market index with the change in the cash up value of their portfolio. 

If the New Zealand share market rose by say, 20% over the last 12 months and their investment portfolio grew by only 10%, then again there is concern around their investment future and the skill set of the investment manager/adviser. 

Interestingly, if the investment portfolio was an exact replica of the New Zealand share market index, then we would have a fair comparison, although the short term nature of it, over the last two or three years or so or the last 12 months, does not give us enough of a sample of time to really get an accurate gauge. 

However, if the investor’s portfolio is a mix of cash, bonds, New Zealand shares, Australian shares and say, global shares, then using the New Zealand share market index as a benchmark to measure performance might prove interesting but is not comparing apples and apples, so to speak.  Bonds are not shares.  It’s a bit like comparing apples and oranges.

Popularity driven prices is a questionable measure

Prices rising, falling or moving sideways are the result, the outcome of market sentiment (the mood of the market).  This is true of individual stocks and whole portfolios.

The point?  Is measuring investment success on short-term price movement, which is based on fickle market mood / emotion really a useful method – seriously?  Are you really happy basing your financial wellbeing and personal economic success on unreliable market driven popularity contests?

If the share price rise of Amazon beats the share rise of Google, does that mean Amazon is a better business?   It might, but how do you know?

The popularity driving the upward movement in Amazon can change in the blink of an eye – then what?

This is where intrinsic value provides some real answers.  Intrinsic value is about the performance of the business – nothing to do with the share price. 

The share price is an outcome (a measure of popularity).

Business performance is a driver…a cause.

That long attention span, hmmmmm….

One of the challenges for working out whether an investment approach is actually working or not is to allow enough time for a useful comparison. 

This is a challenge for many investors because they are looking for a simple clear-cut way to work it out. 

They may be less interested in taking into account some perhaps more complex factors that need to be considered.  Anyway, I cannot say whether it is two years, five years, 10 years or 20 years, that is a suitable timeframe.  I would argue five years would be insufficient.  10 years likely offering a better indication. 

That said, the last 10 years have seen one of the longest bull runs on the markets in history and so this will make some methodologies look quite good and others decidedly average or poor performing.  This 10 year period is not the end game.  It is definitely not a guarantee of what is to come in the future.

For example, investing in index funds or exchange traded funds usually works well in a rising market.  Longer term though, returns are limited by what the market offers, less fees, costs, charges and tax.  There is no way to do better than the market, ever, with this approach. 

This suits defensive investors, who focus mainly on not losing money and who are less interested in maximising their investment results long term.  It also tends to suit those who prefer an academic approach and like to think of the significant amount of mathematics around their train of thought as the “evidence” to support their view. 

Academics are always valid but not always right

Does 1 + 1 = 2?  Yes or no? 

Okay, if I have one orange on the table and then I place another orange on the table, I now have two oranges. 

Let’s say I have one orange on the table and then I place one apple on the table. 

Does one plus one equal two? 

Well, one apple, plus one orange does not equal two apples or two oranges. 

It still equals one apple and one orange.  Yes, I hear you say, “But, one apple plus one orange equals two pieces of fruit.”  Correct. 

Let’s say, we have one puddle plus a second puddle.  One puddle of water, plus a second puddle of water equals two puddles of water.  Now, we combine the two puddles together.  What we do have?  One puddle, plus one puddle equals …?

The point here is that no amount of academic ‘evidence’ is a guarantee that you will be successful as an investor.   Why is it that all accountants are not rich?  Don’t they know a lot about numbers and investing?

Modern Portfolio Theory (MPT) is a good example of a massive amount of investment mathematics and theory, that in the end, whilst considered to be a valid way to analyse markets and investments, is no guarantee of investment success.  

(MPT) is best suited to those unwilling to look beyond defensive investments, playing safe, trying not to lose money. 

Another example (actually, I highlighted this in the August 2017 Investment Perspective, shows that during rising “bull” markets, that a growth style of investing looks better than the value approach to investing. 

Value investing looks rather flat-footed when markets are in this phase, whereas growth investing looks like the winning strategy. 

In my experience, investors settle with an approach that they like, which is often based on their psychological make-up, rather than whether or not an investment methodology is the one that delivers the best outcome. 

Here is what works

 So, back to how to best benchmark your investment portfolio. 

At WISEplanning, we have found that benchmarking an investment methodology, the change in the cash up value over a minimum of ten years (preferably longer) and how this aligns with the investor’s big picture goals and objectives, provides a reliable and relevant measure. 

What seems to work best is designing an investment portfolio, taking into account the investor’s investment risk preferences, goals around capital growth and generating income.  That way, we can adjust the investment strategy using a variety of tools / tactics that help make the money work harder and grow faster over time to line up with the investors goals and investment risk preferences. 

We can still compare the rise in the cash up value of the portfolio with other financial benchmarks too. 

Best though to make sure that above all else, the portfolio hits the target based on the investor’s goals and objectives. 

That is investment success – not trying to outwit fickle markets every other day that have little relevance to an investor’s goals.

“We also look for three things: intelligence, energy, and integrity. If you don’t have the latter, then you should hope they don’t have the first two either.  If someone doesn’t have integrity, then you want them to be dumb and lazy.“

Warren Buffett – Berkshire Annual Meeting 2005