All returns are not created equal

In my last two blogs, I wrote about 1) measuring what matters most: after-fee, after-tax returns and 2) capital preservation: maintaining purchasing power as the prime directive of investing.

Now, I want to bring those two thoughts together with a third: all returns are not created equal. 

Just as investors place undo emphasis on 1) tax avoidance and low fees instead of actual returns, and 2) volatility and “safe” securities instead of the risk of permanent loss and after-inflation purchasing power, I believe investors also commit a third sin: 3) undo emphasis on returns earned over some arbitrary period instead of the process by which those returns were generated.

A quick example here should illustrate my point.

Suppose you were given the choice to invest for the next 10 years with two money managers: Firm C or Firm M.  Suppose, too, that you were presented with their 5 year investing records: Firm C: -6% loss over 5 years; Firm M: +6% gain over 5 years.

For most people (and for me in the past), this is an easy choice.  Over 5 years Firm M has earned a positive 6% return and Firm C has lost 6%, so go with Firm M, right?

But, wait!  How were those returns achieved?  Let’s examine each firm’s annual returns over the last 5 years:

  • $100,000 invest with Firm C
    • Year 1: -4.5%, $95,500
    • Year 2: +1.0%, $96,500
    • Year 3: +1.0%, $97,500
    • Year 4: +1.0%, $98,500
    • Year 5: -4.6%, $94,000
  • $100,000 invested in Firm M
    • Year 1: +4.5%, $104,500
    • Year 2: -1.0%, $103,500
    • Year 3: -1.0%, $102,500
    • Year 4: -1.0%, $101,500
    • Year 5: +4.4%, 106,000

See anything funny, yet?  Don’t worry, I wouldn’t have, either.  Let me explain how those returns were achieved.

As a thought experiment, I put these two investing firms against each other.  Each year, one bets $1,000 that a 6-sided die will land on 1 and get paid $4,500, and the other takes that bet (hoping the die lands on 2 through 6).  In my example, Firm M is making the bet and Firm C is taking the bet.

Now, perhaps, you’re not so sure you want to invest with Firm M!  Sounds more like gambling than investing?  Yes, precisely. 

Each year, Firm M has a 1-in-6 chance of gaining $4,500 and a 5-in-6 chance of losing $1,000.  Although Firm M’s investing record looked pretty good over the last 5 years (because the way the die just happened to roll those 5 times), you may not feel too comfortable now that you know how the return was generated. 

In fact, the next 10 years have a very high likelihood of Firm M losing 4.2% a year and Firm C gaining 4.2% a year.  That’s where the firm names came from: M is for Madoff and C is for Casino.  The odds were on the casino’s side all along, even though the record looked bad over those five years, and the odds were always against Madoff.

And, that’s the point I’d like to make.  Most investors look at an investing record and believe past is prologue.  But, the past is rarely the best judge of the future.  Instead, the right way to judge returns is by examining the method used. 

Two investing firms can have the exact same investing record, but one can generate returns by taking bad bets (and getting lucky) and the other by taking good bets.  You need to figure out which firm is taking good bets to generate satisfactory returns in the future.

This is particularly the case today.  Some firms have deceivingly weak records over the last several years because they’ve taken smart bets and the die has rolled against them.  Other firms have brilliant-looking records although they’ve taken bad bets and the die has rolled in their favor. 

Only by looking behind the curtain will you see if there is a real wizard or a blathering fake.  It may seem trivial or time-consuming, but understanding how returns are generated is much more important than the return record itself–future returns will depend on it (as Madoff so ably illustrated).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

All returns are not created equal

“If only I had…”

The psychology of regret can be very useful in investing.

A recent article by Michael Mauboussin, of Legg Mason, points this out beautifully.

You see, psychologists refer to the tendency to consider what would have happened if you had taken a different action as counterfactual thinking. This way of thinking can work to your benefit, but it can also create traps.

One example of a trap is called inaction inertia. Inaction inertia occurs when you initially fail to take advantage of an investment opportunity, say buying Microsoft in 1996, and subsequently pass over the same opportunity in the future, say buying Microsoft in 1997, because its price has run up from where it was in 1996.

If an investment opportunity is good right now, you should buy regardless of the price you could have gotten if you’d acted earlier. I learned this the hard way with Leucadia in 2002, 2003 and 2004 when I didn’t purchase because the price had gone up, but then finally got it right in 2005.

A benefit of the psychology of regret results from learning about errors of action versus errors of inaction. You see, some regret is good because it encourages future changes in behavior.

Most of us tend to focus on short term regrets related to action. Like, I wish I hadn’t eaten that whole platter of brownies.

But, it can be equally beneficial to also focus on regrets related to inaction. Warren Buffett is famous for bemoaning the investments he didn’t make more than the investment he did make. He knows his greatest investment errors were sins of omission rather than commission.

If you consider both the investments you’ve made as well as the investments you haven’t made, you can learn from your mistakes and become a better investor.

One of the biggest psychological traps investors fall into is due to their psychological immune system. This system exists to help bad situations seem better, but they can lead to big investing mistakes.

“First, we tend to explain away situations in a way that makes us feel better.” Like, someone who gets turned down for a job and tells themselves they didn’t want it anyway. This kind of thinking leads to investing errors that aren’t learned from. Don’t explain away errors dismissively, try to understand what went wrong.

“Next, we seek facts that support our views and disavow or dismiss factors that don’t back us up. This is known as the confirmation bias.” If you read every article that says that Google or Apple is the greatest investment ever, but fail to read the articles critical of those companies, you probably won’t make good investment decisions. Look for evidence that your investment ideas may be flawed.

“We also exhibit hindsight bias. Once an event has passed, we tend to believe we had better knowledge of the outcome before the event than we actually did.” How many people insist they knew an investment would do well but failed to act. Did they really know it beforehand, or are they just convincing themselves they knew after the fact? Write down your thinking beforehand and you’ll find out what you really thought instead of what you hazily remember you thought.

“Finally, when we make a prediction or take an action that doesn’t work out, we believe we were almost right–the close-call counterfactual.” If I had a dime for every investment I almost made and went up, I’d have a lot more money than I do. Once again, write down what you think beforehand, then you can check to see whether your close-call wasn’t just a rationalization after the fact.

To avoid making mistakes with the psychology of regret, “be aware of how the mind works and the suboptimal behaviors that may ensue.” If an investment is good, make it regardless of the price you could have paid if you’d invested earlier. Be sure to consider your inaction as well as your actions. There may be a lot to learn from what you didn’t do.

Also, “be careful not to kid yourself.” Don’t just explain away situations in a way that makes you feel better. Look for disconfirming as well as confirming evidence. Write down what you think will happen beforehand so you can check whether you are suffering from hindsight bias or the close-call counterfactual.

Understanding the psychology of regret just may make you a significantly better investor. It sure has helped me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.