Assessing Investment Performance

“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.

Annual Performance

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.

Multi-Year Performance

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.”

Disclosures:  None

 

The Problem of Rational Capital Allocation

“In theory there is no difference between theory and practice. In practice there is.” — Yogi Berra

Imagine that you are the founder of a highly successful small chain of restaurants.  After immigrating to the United States from Italy as a teenager, you built up a modest amount of capital working several jobs and living an extremely modest lifestyle.  Finally, you opened a neighborhood Italian restaurant in midtown Manhattan in 1980 at the age of twenty-five.  It was not so much a restaurant as a tiny storefront offering take-out specialties and serving a lunch crowd.  Within a couple of years, lines were forming by 11:00 am and persisted for three hours or more each day.  Loyal patrons said that there was nothing remotely like it in the city.  Over time, you were able to raise prices at a rate moderately exceeding inflation with no noticeable drop off in demand.  This was followed by an expansion into a larger location with seating and, eventually, into a chain of eight nearly identical restaurants in Manhattan.

At the age of sixty, you have amassed a comfortable fortune, held mostly in cash, having elected to retain the vast majority of your historical profits rather than expand more aggressively.  You are happy with the lifestyle and financial security provided by your small restaurant chain and not particularly concerned about optimizing your business strategy any further.

You have achieved the American Dream.

Our example is fictional but chances are most readers could identify at least a few familiar examples of such a business.  The United States is full of highly profitable niche businesses that have created massive economic moats and must enjoy abnormally high returns on equity as a result.  In most cases, the founders of these businesses are tremendously skilled at the operational details that made their business into a success but either do not have the skills or lack the inclination to act as capital allocators.  But this may not be a tragedy.  At a micro level, sometimes optimization isn’t necessary to serve the purposes of a small business owner.

From Horatio Alger to Business School

But what if our fictional protagonist had chosen an alternate path to the American Dream?

Rather than choosing up-from-the-bootstraps entrepreneurship, our young immigrant could have focused on academics, graduated from college, and secured admission to one of the elite business schools.  It is likely that a man capable of extreme success in entrepreneurship would have found a way to graduate from business school with an elite MBA.  In theory, such an education would provide not only the tools to succeed from an operational perspective but also the added capability of being skilled when it comes to capital allocation.  After a couple of decades in the trenches, would it not be reasonable to expect that the same level of skill required to achieve success operationally would also be present when it comes to capital allocation, broadly defined?

In fact, this is a key question that is not asked nearly often enough.  If we assume that the large enterprise in question is a publicly traded company with a broad shareholder constituency, it is no longer remotely acceptable to focus only on operations and neglect capital allocation.  Unlike a small entrepreneur who might be perfectly justified to not focus much attention on capital allocation matters, this issue is of prime importance for the chief executive of any public enterprise.  Despite this importance, many CEOs are shockingly unskilled at capital allocation.  Having risen through the ranks through operational disciplines, capital allocation sometimes seems like a mere afterthought or, even worse, as a tool for obfuscating the true economics of an enterprise.

Oil Majors’ Dividends Survive Crude’s Plunge!

On Monday, November 16, a front page article in the Wall Street Journal documented how the world’s biggest energy companies have “doubled down on their promise to protect dividends, despite a precipitous drop in profits this year, driven by a steep decline in oil prices.”  The shares of large energy companies have long been havens for shareholders interested in receiving a regular stream of dividends, as the reporter notes:

Oil majors have little choice but to pay fat dividends to keep investors.  Most of these companies don’t offer investors compelling growth prospects as they struggle to replace even the millions of barrels of oil pumps every year.  Fat dividends are a crowd-pleasing but potentially risky strategy given concerns about the length of the current price downturn and its impact on cash flow.

The article goes on to describe the long term dividend record of the oil majors.  Many have longstanding records of rising dividends spanning multiple decades.  For example, Exxon has increased its dividend at a 6.4 percent annualized rate over the past 33 years.  CEOs openly admit that the dividend is paramount in their decision making process.  “This is all about making sure we can continue paying dividends to our shareholders,” said Royal Dutch Shell CEO Ben van Beurden.

At first glance, perhaps this attitude makes sense.  After all, a company is owned by its shareholders.  Large energy company shareholders overwhelmingly care about the dividend and the managers they have hired align their own behavior with the wishes of the owners.  So where is the problem?

Ultimately, companies attract the shareholder base they deserve.  If regular, recurring, and rising dividends are the end-all of a company’s existence, that is all well and good as long as the owners understand that they might be acting in a sub-optimal manner in order to generate this result.  Are shareholders looking at the overall capital allocation situation and thinking about how to best allocate free cash flow to maximize the overall intrinsic value of the firm in the long run?  Is a recurring and rising cash payout, made regardless of underlying business conditions, a way to optimize intrinsic value over time?  One gets the sense that these considerations are not openly and explicitly considered.  There is no point in picking on energy companies in particular.  Irrational thinking about capital allocation is pervasive in many other industries as well.

A Clean Slate

At the risk of being excessively theoretical, let us step back and consider what rational capital allocation might look like if one ignores past precedent, the cash dividend preferences of current shareholders, and the bias of current managers.  Even if the theoretical conclusions we draw are not entirely realistic in practice, it should help to consider what is optimal and then consciously depart from the optimal, when needed, in the interests of pragmatism. 

If the future could be foreseen perfectly, the intrinsic value of any firm rests on the free cash flow the business can generate over its remaining life discounted back to present value at an appropriate rate.  Obviously, one cannot actually know the precise timing and magnitude of cash flows even for the next few years let alone the remaining life of a typical business.  However, this is the theoretical place to start.  Once we begin to focus on free cash flow, it also becomes apparent that it is critically important to determine what a firm does with such cash flows.

At a basic level, a firm can use free cash flow for the following purposes:

  • Invest in internal expansion opportunities.  Widen the moat of the existing business through the intelligent allocation of capital as opportunities arise.  Our small restaurant owner chose to modestly expand the size of his chain from a single storefront operation to eight restaurants over thirty-five years.  Larger businesses invest internally as well.  For example, Burlington Northern Santa Fe makes investments in enhanced locomotives, track infrastructure, and technology designed to deepen its competitive advantage.  These investments go beyond the bare minimum capital investments required to simply maintain the characteristics of the existing business.  They are meant to widen the company’s moat.
  • Invest in external expansion or diversification.  A firm can use its free cash flow to acquire another business either within its existing business lines or in entirely different areas.  This is usually done in order to consolidate market share, capture “synergies”, or otherwise make the resulting enterprise more valuable than the sum of each operation standing alone.  More rarely, a conglomerate structure can be pursued in which a business acquires a totally unrelated business.  Of course, Berkshire Hathaway is the prime example of a successful conglomerate that readily comes to mind.  Usually, there must be some special skill present in management that justifies bringing multiple unrelated businesses under one corporate roof.  Chief Executives of conglomerates must be exceptional capital allocators.  Note that an investment program in marketable securities is essentially an external expansion diversification.  A firm is becoming a small fractional owner of businesses unrelated to its core operations.  Again, Berkshire Hathaway is a good example.  Charlie Munger’s Daily Journal Corporation is another example.
  • Pay Down Debt.  A firm can choose to deploy free cash flow toward changing its capital structure by reducing debt.  There are numerous theoretical constructs regarding the “optimal” level of debt that a firm should employ and this goes beyond the scope of our immediate concern regarding capital allocation.  A debt-free balance sheet is certainly a sign of conservatism yet there are legitimate reasons to carry debt even if a firm has abundant free cash flow available to become debt free.  Common reasons include tax efficiency as well as distortions caused by a high tax burden on American firms associated with repatriating cash from overseas operations.
  • Return Capital to Shareholders.  If internal and external investment opportunities are scarce and the level of debt is optimal, a firm may return capital to shareholders in two ways:
    • Cash Dividends.  This is the most common way in which a firm can return capital to shareholders and it is a very simple process.  A dividend is declared and paid out to all shareholders on a per-share basis, and all shareholders are left to address the tax consequences of the dividend for themselves.  Tax consequences can vary widely depending on the shareholder base.  While it is normal for a firm to declare a quarterly dividend and either hold it constant over time or steadily increase it, this is not a pre-requisite for the use of cash dividends.  Although unconventional, some firms choose to declare irregular cash dividends and establish no expectation regarding dividend recurrence over time.
    • Stock Repurchases.  Repurchases used to be quite rare but are now a very common means of returning cash to shareholders.  However, the motivation for many repurchase plans isn’t primarily related to returning cash to shareholders.  Instead, management may wish to “neutralize” dilution due to option issuance or may be seeking to temporarily boost the company’s share price.  There are complicated incentive systems at work that could very well lead to completely non-economic reasons for stock repurchases. The only rational reason to repurchase stock is when shares are available in the market at a price that is demonstrably less than a conservative estimate of a firm’s intrinsic value.  If such a condition does not exist, stock repurchases will destroy value regardless of the motivation behind the repurchase.

The listing above is hardly ground-breaking and forms the key set of principles that executives are supposed to consider when making capital allocation decisions.  Obviously, anyone who has earned an elite MBA, or any MBA for that matter, would be familiar with these core principles.  So why is it that we often see clearly sub-optimal decision making such as recurring cash dividends raised in an annual stair-step manner regardless of underlying business conditions?

Back to the Real World

As Yogi Berra famously noted, there is a big difference between theory and practice when it comes to operating in the real world.  Having the best intentions and following a sound and principled capital allocation process may not always be possible in all settings due to long standing institutional biases and shareholder expectations.  It would be utterly naive to suggest that a new CEO of a long established business engaged in irrational capital allocation practices could change the approach immediately.  Instead, what investors should look for is an overall approach consistent with rationality even if certain aspects may not be strictly defensible.

The first consideration is whether a firm has free cash flow available to deploy.  This is not necessarily a measure that must be taken on an annual basis and can perhaps be viewed in a normalized sense.  For example, a good business with a solid underlying moat may in fact be cyclical and lack ample free cash flow in periods when major investment opportunities exist.  The normal cyclical variances in free cash flow should not rigidly determine whether investment opportunities are exploited.  For a strong firm, it may very well make sense to engineer major acquisitions in times of business weakness by using debt or common stock, if shares are not especially undervalued.  In so doing, the long term intrinsic value of the business could be enhanced.

It is much more questionable, however, to continue paying large and rising cash dividends during times of weak free cash flow.  While certain investor groups may like the idea of steadily rising dividends, very few businesses have underlying economics that make such a dividend policy intelligent.  In the real world, variances in free cash flow will exist and should be taken into account when paying out dividends.  A rigid policy of fixed or rising dividends could actually impede intelligent expansion or acquisition opportunities in difficult economic conditions because, in addition to weak free cash flow, the firm will have to find cash for dividends.

For firms paying dividends, it makes more sense to either establish a variable dividend policy in which the annual payout varies completely based on economic conditions during the year or a very small dividend likely to always be covered by free cash flow plus a variable dividend, or “special dividend” determined based on available free cash flow.  Progressive is a good example of a company with a variable dividend policy.  A policy of special dividends has been popular among offshore oil drilling firms such as Diamond Offshore in recent years.  Such a policy is especially well suited for the highly cyclical oil industry, despite the attitude of the oil majors cited in the Wall Street Journal article.

If a firm chooses to pay a dividend while also repurchasing shares, it is incumbent upon the management to clearly explain why this decision has been made and what drove the proportion of cash return via dividends versus repurchases.  Repurchases should only be made in conditions where the share price is clearly and demonstrably below intrinsic value.  A clear warning sign of irrational capital allocation is a fixed share repurchase authorization that calls for buying a certain amount of stock each year regardless of the share price.  Sometimes firms even openly admit that they are doing this to offset stock option dilution.  However, this is irrational.  The issuance of stock options is a compensation issue, not a capital allocation matter.  Issuing shares to employees and repurchasing shares are two totally distinct transactions, despite the apparent need for some firms to pretend otherwise.

Rational and Practical Capital Allocation

Chief executives should ideally be competent operational managers as well as skilled capital allocators.  These skills are two sides of the same coin when it comes to achieving satisfactory returns on shareholder capital.  If a CEO is not a skilled capital allocator but is excellent operationally, perhaps the capital allocation function can be overseen by an independent director but this is hardly an ideal situation.  The Chief Executive must be the ultimate person accountable for overall returns to shareholders.  Excelling operationally while squandering the resulting wealth on indefensible capital allocation is hardly a good overall record.

Investors should be cognizant of the many historical and cultural reasons behind dividend policies that may not withstand strict scrutiny when it comes to optimizing capital allocation.  In such cases, the focus should be on not compounding past mistakes.  If a firm has a dividend in place, perhaps it is more practical to leave it in place but stop automatically increasing it in a stair-step manner each year regardless of business conditions.  Over time, inflation and real growth of a good business will reduce the economic meaning of a nominally fixed dividend and allow for incrementally better capital allocation without forcing a confrontation with established interests resistant to any change.

It is far less forgivable to tolerate share repurchase programs that lack rational economic merits.  A CEO who tolerates a repurchase of shares at high prices merely to offset stock option dilution or to temporarily boost the price of the stock is unworthy of shareholder trust and does not deserve to retain his or her job.  If a CEO puts in place a repurchase program, it must be clearly defended as accretive to the wealth of existing shareholders.  Any company repurchasing a fixed dollar amount of stock each year is almost certainly failing this test.

Ultimately, capital allocation will drive the real returns of investors over long periods of time.  Investors who ignore this key function and tolerate sloppy thinking and reasoning from their managers are likely to suffer lower returns over time compared to investors who demand a higher standard, even if that standard eliminates the vast majority of investment candidates from consideration.

The Individual Investor’s Edge

“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” — Warren Buffett, 2013 Letter to Berkshire Hathaway shareholders

As Albert Einstein wisely stated, compound interest is the eighth wonder of the world:  He who understands it earns it while he who doesn’t pays it.  The vast majority of individuals who take the initiative to accumulate savings should follow Warren Buffett’s advice on using index funds and dollar cost averaging to achieve satisfactory returns over time.  For those earning at or above the median wage in the United States, it would be very difficult to end up poor if one simply saves ten to fifteen percent of gross income and dollar cost averages into the S&P 500 over several decades.

But what about non-professional individual investors who want to achieve better than average results?  In the short run, the stock market resembles a manic-depressive character who bids up prices one day and sends them down the following day without much of a reason for the change in sentiment.  Benjamin Graham’s “Mr. Market” character perfectly personifies the psychology of financial markets in the short run.

Any individual who pays attention to the markets can observe this insanity and it is seductively easy to draw the logical conclusion:  If the markets are so crazy, why not try to profit from the insanity?

Circle of Competence

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” — Charlie Munger

One of the ironies of financial markets is that while short term action may appear utterly stupid, it is a grave mistake to assume that market participants are individually stupid or that it is somehow easy to outperform market averages by actively trading.  Investors would do well to constantly think about the fact that there is another equally motivated investor on the other side of every trade they are considering.  That investor may resemble Mr. Market’s irrationality at any given time, or he may have superior insights into the security in question.

The existence of superior insight is often referred to having a “circle of competence” encompassing the activities of the business or industry in question.  To claim that an industry falls within one’s circle of competence is not to be taken lightly.  It involves far more than being familiar with a company’s product line or reading about the industry in question in the newspaper.  One must possess expert knowledge of the subject matter to possess superior business insights that other market participants do not also possess.  For most non-professional individual investors, this type of insight is only likely to exist in subject matter related to the investor’s profession.

The problem is that most investors would be ill advised to concentrate their personal investments in their employer or its competitors since there would then be a correlation between the individual’s source of employment income and the performance of his investments.  A general industry downturn could cost the investor his job and, at the worst possible time, result in a severe depreciation in his investment portfolio.  Few individuals, even those with a reasonable emergency fund, would find this correlation of misfortune to be a pleasant experience.

But is it not possible to obtain competence in fields outside one’s area of employment?  It certainly should be with enough intelligence, dedication and effort.  Few individual investors are going to be motivated to spend the time and energy required to truly understand multiple industries, let alone develop special insights that professionals do not have.  It is certainly not impossible for a small percentage of individuals to possess this ability.  However, it would certainly be very difficult for most investors to do so.  On the other hand, it may not be that difficult to obtain a working knowledge of various industries and businesses.  In this case, an individual would possess knowledge that is at least as good as other market participants but perhaps have few, if any, special insights into the industry or business in question. Can such an individual expect to show any meaningful results in exchange for the effort?

Timeframe Arbitrage

The enterprising individual investor has one major advantage that nearly all professional investors lack:  there is absolutely no logical reason to care about short term performance when evaluating investment candidates.  To the extent that commitments to common stocks have a timeframe measured in several years (ideally five to ten years or longer), there is really no reason whatsoever to care about the price movements of the investment over the next week, month, quarter, or year.

The ability to take such a sanguine view of the world is limited to non-existent for the vast majority of professional investors.  Professional investors who are engaged in active management of a portfolio are evaluated based on their performance relative to other active managers as well as benchmark indices.  Professional prestige, career advancement, and compensation hinges on short term performance.  For this reason, many professional investors “closet index” in an attempt to closely replicate the results of a benchmark and deviate from this practice only when they believe that doing so provides an edge in the short run.  The pain of falling far short of a benchmark can be far greater than the pleasure of exceeding it.

It is true that there are many value oriented professional investors who take a longer term perspective.  However, such investors are still not immune to shorter term comparisons.  It is striking how many value oriented hedge fund managers publish quarterly letters to shareholders in which holdings are analyzed based on performance over a meaningless timeframe.  Why is this done?  Clearly investors demand that kind of feedback from managers and it is necessary to comply with this demand in order to retain assets under management.  Even with a long term mindset and the best of intentions, it is hard to see how a value oriented professional investor can make decisions to maximize value in 2020 when he knows that it will be necessary to explain short term price movements a couple of months from now when year-end 2015 results are reported.

Conclusion

Most individual investors are well advised to simply save as much of their income as possible and dollar cost average into one or more low cost index funds over many decades.  Using this approach, one need not make exceptional amounts of money to retire with a greater net worth than the vast majority of Americans.

With success virtually assured using such an investment approach, one must have very good reasons to deviate and embrace active portfolio management.  Still, many enterprising investors will seek to do better either because they wish to accumulate capital at a faster rate or simply because they enjoy the process (the most successful with have both characteristics).  Such investors will need to develop a working understanding of a number of industries and businesses to have a decent prospect of outperforming a benchmark index over time.

But do they require the truly superior insights implied by the circle of competence concept?

Surely having superior insights is something an investor should aspire to achieve since the truly big winners most likely require such insight.  However, achieving insights that put the individual on par with professionals operating in the same industry could be sufficient if the individual investor harnesses his or her major advantage:  timeframe arbitrage.  By doing so, the individual can invest in situations that may appear compelling to a professional in the long run but not in the short run.  The individual will view himself as trading with people who are not stupid but simply have different priorities and goals.