“The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer …. Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.” — Howard Marks
The end of a calendar year is typically a time for reflection and contemplation for most people, both on a personal and professional level. If such reflection is to be more than a surface level passing thought, one must bring a certain amount of discipline and rigor to the process. One year is plenty of time to assess the success or failure of a diet, exercise program, or quitting smoking but it is but a short blip of time in the world of business. Since all intelligent investing puts the investor in the role of a businessperson, it follows that a single year is not a meaningful timeframe to evaluate investment performance either.
The vast majority of professional investors do not have the luxury of claiming that one year is an insufficient amount of time to evaluate performance. The incentive structure and culture of most firms make annual performance paramount and the individuals and institutions entrusting funds to money managers often have even shorter frames of reference. This is why closet indexing, window dressing, and other counterproductive actions are so prevalent. Fortunately, individual investors do not face these institutionalized pressures. An individual investor’s worst enemy is likely to be himself and therefore the struggle is internal and mostly a matter of temperament and personal discipline. In this article, we ignore the pressures facing professional investors and focus on how to rationally assess performance in a way that can be implemented by individuals.
One year is not a long enough period to assess performance but obviously longer periods are made up of shorter chunks of time. As a matter of convention and convenience, it is natural for investors to look at performance annually. This is not harmful as long as these annual periods are viewed in a longer term context. Most investors probably look at annual performance but it is apparent from reading news articles and comments in venues such as Twitter that, in many cases, performance is not viewed correctly especially relative to benchmarks.
Investors who utilize brokers such as Vanguard or Fidelity can delegate the task of measuring their overall annual performance to the figures presented on annual account statements. Those who prefer a more proactive approach can easily create a spreadsheet in Microsoft Excel that calculates the internal rate of return (IRR) of a portfolio based on transaction activity during the course of a year. Such a spreadsheet must include the beginning account balance along with all additional purchases, sales, income received, commissions paid, and the ending account balance. Depending on the complexity of an investor’s situation, it might be useful to calculate the IRR of sub-accounts such as taxable and tax-deferred accounts separately. This is particularly useful for sub-accounts employing significantly different investment strategies.
Most United States based investors tend to use the S&P 500 as a benchmark but there isn’t really anything written in stone dictating the use of this benchmark. Investors employing strategies focusing on very specific niches, such as small capitalization stocks, should probably pick a different benchmark. It is critical to include dividends in the performance of the benchmark. Most articles and tables in newspapers present only the price change of an index rather than total return. This can be meaningful. For example, in 2015, the S&P 500 had a slightly negative return based on price alone but a slightly positive return when dividends are considered.
Some investors prefer to use an investable benchmark such as the SPDR S&P 500 ETF (SPY). The argument for doing so is that one cannot directly invest in the S&P 500 and must bear the small costs of an ETF or other index fund to implement a passive investment strategy. In reality, whether one uses the S&P 500 or SPY is not likely to materially impact the question of whether an investor possesses sufficient skill to actively manage a portfolio.
Once a benchmark is chosen, it is important to not make changes to which benchmark is used except when clearly justified. It is also intellectually suspect to switch to a different benchmark retroactively in an attempt to make performance look better. Ultimately, all an individual is doing is fooling himself with such actions. Benchmarks should only be changed if there is a clear change in strategy that fully justifies the change and benchmarks used in past years should not be retroactively changed.
If we refer to the quote by Howard Marks at the beginning of this article, it is apparent that skill must be measured over multi-year periods. But how many years is sufficient to determine whether an investor has skill?
It is not a good idea to refer to a fixed number of years as a sufficient amount of time to measure skill. Instead, it is important to consider the overall market environment and pick a timeframe that includes both a major bull and bear market. Why is this the case? It is very possible, and indeed likely, that an investor with a proclivity for taking huge risks will dramatically outperform a benchmark over the course of a strong bull market. It is difficult to know whether the investor took these risks intelligently or not without observing performance during bear markets. It is also possible, and very likely, that an exceedingly risk averse investor will dramatically outperform a benchmark during a severe bear market, but it is difficult to know whether such an investor was uncommonly wise or just inherently incapable of taking intelligent risks without observing performance during a subsequent bull market.
In general, stocks tend to rise over long periods of time. In the sixteen years since the turn of the century, the S&P 500 had a positive total return in twelve years. The last year in which the S&P 500 had a negative total return was in 2008. With the exception of 2011 and 2015, which featured low single digit returns, the S&P 500 has posted very strong double digit positive returns over the past seven years.
Based on the performance of the overall market in recent years, it is difficult to be confident that an investor possesses real skill without looking at a record that spans at least a full decade.
If we have access to an investor’s record from January 1, 2006 to December 31, 2015, we would be able to observe performance during the tail end of a bull market, through one of the worst bear markets in generations, as well as during the subsequent bull market that is still underway. An investor who took imprudent risks in 2006 and 2007 would likely have faced ruin in 2008 that more than fully offset the gains of the good years, and reduced the capital base to the point where significant outperformance during the last seven years would be required just to match the benchmark. An extremely risk averse investor incapable of taking intelligent risks would have been saved from much of the agony of 2008 but would likely have not participated in the current bull market.
This Presents a Dilemma …
Active investing is not without costs in terms of time, effort, transaction costs, and the very real possibility that performance will fail to match totally passive alternatives. At least in recent history, it is difficult to know whether an investor has any skill without a track record of a full decade. How can investors with less experience or an investor just starting out begin to determine whether the effort is worthwhile?
For new investors, one of the most important factors to consider is whether the process itself is rewarding and fulfilling. If reading 10K reports and similar documents is not your idea of a good time, it is exceedingly unlikely that active portfolio management makes any sense. Investors who outperform must have a passion for the process. They must find it intellectually rewarding in and of itself without considering the superior returns that might be achieved. When a passive approach is available at very low cost, why even bother to find out if real investing skill is there if the process itself is not enjoyable? This is particularly true when anyone earning the median income in the United States can almost certainly achieve financial security with a 10-15 percent savings rate over a long career. For high income earners in fields outside investing, a passive approach coupled with a healthy savings rate is more than enough to guarantee financial security.
This leaves the question of how to evaluate the performance of an investor who has only been operating during the course of the current bull market. Many investors with significant skill could very well not outperform during a bull market with this prudence more than amply rewarded during a subsequent bear market. As a result, simply looking at raw performance numbers over the past few years is not sufficient to make an informed judgment. If an investor has significantly outperformed in recent years, that isn’t necessarily proof of superior skill either. It could be the result of luck and blind risk seeking behavior. The only way to judge performance without a longer track record is to examine individual decisions and try to determine if they were intelligent and well thought out. This requires that the investor has prepared an investment thesis, or at least an informal note, documenting each decision that was made. Unfortunately, self evaluation is difficult and some type of peer review may be necessary to retain intellectual honesty. An investor in this situation might, at least at an intellectual level, hope for a bear market in the near term as it would likely demonstrate whether their skill exists or not.
One Supplemental Measure
The use of a benchmark to measure performance is important but perhaps a more interesting metric is to attempt to learn if you are your own worst enemy when it comes to trading. A very simple way to do this on an annual basis is to track the performance of your portfolio as if you had made no changes throughout the year. Measure this figure against the actual performance of the portfolio. Although a year is not really sufficient to judge the success or failure of a trade, if one finds that trading is consistently detracting from results, it is an important sign that a different perspective could be useful. Some of the best investors are extremely inactive. Charlie Munger’s investment portfolio at The Daily Journal has been unchanged for years after he chose to deploy cash very close to the bottom of the market in early 2009. As Mr. Munger says, “Investing is where you find a few great companies and then sit on your ass.”