Performance Does Matter
Rich Rund
Dir. Client Services & Business Development
As we head into the 11th year of an economic expansion, most investors with exposure to the US stock market during this period have become accustomed to positive returns. In periods of prolonged prosperity, investors can become complacent. Investors have a responsibility to be good stewards of their investment assets. Broadly speaking this means setting realistic investment goals based on their needs and time horizons, knowing their tolerance for risk, and allocating their capital to an asset class mix that is consistent with their goals and the level of risk they are willing to take over the anticipated time horizon. Many investors do not feel qualified to do this on their own, and may choose to work with an advisor.
I have had hundreds of conversations about investing with individual investors. When I ask them about the performance of their investments, a typical response is along the lines of, “My performance is great! I had a fantastic year.” However, when asked for specific portfolio data like “total return” or “performance relative to a benchmark” these same investors often have no quantitative information on how their investments have actually performed. Occasionally, I get the opportunity to sit down and evaluate actual performance with these individuals. When I do, I discover most investors underperform the broad market (more on this later). However, they think they “had a fantastic year” because their statement balance at the end of last year was larger than the year prior.
Similarly, I have dozens of conversations with wealth management colleagues about performance. I often hear the same thing: my clients and I don’t really focus on performance. I believe this is a mistake.
“Underperforming in good times can potentially be worse for your overall portfolio than outperforming in bad times. ”
Portfolio performance should never be overlooked. Performance evaluation is the cornerstone of being a good steward of investment capital. Proper evaluation of investment performance helps investors make informed decisions on asset allocation choices. It also allows investors to hold advisors and asset managers accountable for their decisions. All assets managers and advisors should be able to provide historical investment performance against an appropriate benchmark for a given strategy or portfolio. If an advisor cannot provide this information or uses managers that consistently underperform their respective benchmark, it might be time to have a heart-to-heart.
It is important to evaluate performance in good times and in bad times. In fact, underperforming in good times can potentially be worse for your overall portfolio than outperforming in bad times. Consider that the market typically moves up more than it moves down. Over the last 25 years, the market (as represented by the S&P 500 Total Return Index) has had up days 55% of the time with an average “up” day return of 0.77%. That compares favorably to the down days 45% of the time and average “down” day return of -0.82%. Despite a slightly larger impact of negative returns on “down” days, over the 25 year period the index delivered a compounded annual average return of 10% per year.
Consider a hypothetical investor named Warren. Warren is 65 years old and is comfortable with his retirement savings. He has an additional $1 million he wants to invest in an account for 20 years that he is going to bequeath to his children and his alma mater. Warren decides to invest conservatively in a strategy that aims to reduce volatility, he can accomplish this goal investing 60% of his portfolio in 10-year treasuries and 40% in the S&P 500 (60/40 Portfolio). Average annual return for the S&P 500 equity index over the past 15 years is a little over 9%, and current 10-year treasury yields are around 1.6%. As with most market forecasters, I expect the next 20 years will not be as good for equity and that interest rates will remain low. Therefore, 7.5% and 2% seems like a reasonable estimated expected return for the S&P 500 and 10-year treasuries, respectively. With an expected weighted average annual return for this portfolio of 4.2%, Warren would see the growth shown in the chart above.
After 20 years, Warren’s $1 million turns into over $2.5 million. I believe it was Einstein who said the strongest force in the universe is compound interest.
Now, let’s look at a portfolio that tries to maximize returns by being totally exposed to equity through investing in a passively managed index fund that tracks returns of the S&P 500. This is an appropriate approach for Warren given his goals (maximize portfolio for his bequests) and time horizon (20 years). As before, we will use 7.5% estimated annual return.
An additional 3.3% per year in performance from passive equity exposure yields an additional $1,970,896 after 20 years. This represents a significant increase over the results of the “conservative” portfolio.
Finally, let’s imagine Warren believes in active management and chooses his own managers. He evaluates asset managers against appropriate benchmarks and holds them accountable. He selects managers that seek to outperform the market and are able to add an additional 1% to his passively managed all equity portfolio and an additional 4.3% to the 60/40 portfolio.
A 1% increase in annual returns over 20 years leads to an additional $864,195 relative to the passively managed portfolio.
It is important to point out that the above example makes a lot of assumptions. One assumption is linear annual returns. Obviously, market returns are volatile, and performance does not move in a straight line. However, this is kind of the point. A long time horizon allows an investor the ability to disregard short-term market volatility. Another assumption, in the third example, is that Warren can successfully select active managers that outperform passively managed indexes. This is difficult to do, but not impossible. Good active managers generally have a consistent investment process and concentrated portfolios that are meaningfully different from investable passive alternatives. Often, managers can add value beyond investment performance in the form of good advice and objective factual data.
Despite the potential additional gains of an equity heavy portfolio, most investors underperform broad market benchmarks. Even after accounting for fees and expenses that are not included in market indexes, investors underperform, and sometimes by a significant percentage. While complacency may be a factor, the primary reason this happens is psychology.
Psychology
There have been behavioral studies that suggest the psychological pain of a loss is about twice as powerful as the pleasure of an equivalent gain1. The term for this is loss aversion. In general, people tend to be more concerned with avoiding losses than achieving gains. This concept helps explain why investors will often make sub-optimal decisions in the face of negative market volatility. As the market starts to decline the psychological pain of the loss becomes too much, and the investor exits the investment. Even the most novice investors know they are supposed to “buy low and sell high”, but loss aversion often results in investors pursuing the opposite behavior – selling low (panic selling) and buying high (fear of missing out).
Loss aversion has led to a plethora of investment products and strategies which aim to ease the pain of loss or protect against downside deviation. While these strategies may protect on the downside, the protection is almost always at the expense of performance on the upside. In addition, many professional advisors have built practices that focus on conservative consistent returns based on loss aversion. At best, these practices are taking into account investor behavior and trying to protect investors from making irrational decisions. At worse, the advisors realize the best way to retain a client is to avoid losses. A conservative approach is not always ideal for reaching the full potential of an investment portfolio.
A reasonable alternative is to invest conservatively for short-term needs, and invest in asset classes that provide the best expected returns regardless of volatility for long-term goals. This “short-term/long-term” investment approach provides a cushion of safety and helps investors resist the psychological fears that affect investors during a period of negative market volatility.
A consequence of loss aversion is that investors do not take into account the opportunity cost of lower overall returns in their portfolio in exchange for perceived relative safety.
Investors owe it to themselves and their legacy to be good stewards of their assets. Do not let psychology, complacency or ignorance interfere with sound investment principles. Instead, hold professional advisors and investment managers accountable by evaluating performance against appropriate benchmarks and investment goals. This is something we at Shaker do regularly for our clients and other interested individuals. Please contact us if you would like to set up a complimentary review.
1. Kahneman, D. & Tversky, A. (1979). "Prospect Theory: An Analysis of Decision under Risk".
Past performance is not indicative of future results. Investing involves certain risks including loss of principal. There is no guarantee that the investment objective will be achieved or that any investments or strategies discussed in this publication will be equally profitable in the future. Forward looking performance information and assumptions included in this article are for illustrative purposes only and may not prove to be correct. It is not intended as investment advice or recommendation, nor is it an offer to sell or a solicitation of an offer to buy any interest in any fund or product. Information herein has been obtained from public sources and we do not guarantee its accuracy.