Measuring long term performance

One of the things that really hurts individual investors is not focusing on long term performance.

In repeated studies by Dalbar, they find that individual investors, on average, receive only about one quarter of the return generated by the average mutual fund. When funds are up 12%, they get 3% returns. When funds are up 8%, they get 2%.

One reason is bad advice. Not all planners and advisors are experts in their field. In fact, many have huge conflicts of interest in the advice they give (like a 5% commission on the gross value invested into a fund they “recommend” to you).

Another reason is fees. Investors are frequently unaware of the up front, on-going, and back end fees they are paying (especially in 401(k) plans). High fees eat into returns over time, sometimes dramatically.

A third reason is chasing performance. Investors, whether through bad advice or on their own, tend to sell what does poorly and buy what does well. The Dalbar study mentioned above showed that investors as a whole would actually do better if they stayed put. That may sound counter-intuitive, but it works.

One element that complicates this investment selection process is that most investors don’t understand the numbers they’re presented. Specifically, many investors focus too much on short term returns when they need to focus on much longer time periods. This is through little fault of their own; no one sits students down in high school or college and explains compounding interest and the noisiness of market data (why not!?).

Let me give an example of my performance over time to illustrate this point. For my growth investors I’ve beat the market (after fees) by approximately 1.7% annualized over the last 4 years and 8 months. But, that performance didn’t come smoothly (just ask my clients). It came in fits and starts that would confuse anyone looking solely at short term returns.

For example, I beat the S&P 500 only 45% of the 56 months invested. How could I beat the market if it were only 45% of the time? Like I said, because performance comes in fits and starts. If I beat the market by a large amount 45% of the time and lose by a small amount 55% of the time, I can still beat the market.

I beat the market 51% of the quarters invested, 67% of the years, and 100% of the 3 year periods. Longer periods are more meaningful.

Does that mean 3 years is enough time to measure? No! Looking at my personal portfolio over the last 14 years (after deducting a simulated fee), my numbers are 53% of months, 53% of quarters, 65% of years, 69% of 3 year periods, 89% of 5 year periods, and 100% of 7 and 10 year periods. Once again, longer periods reveal more information.

Does that mean 7 years is enough? No! Even the best money managers under-perform over long periods. A lot of great managers have racked up poor results over the last 10 years even though they will probably do better than average going forward.

Measuring long term returns is only a part of the equation of selecting a money manager. Selecting someone because they out-performed one month, quarter, year or even 3 year period is foolish. There is too much noise in markets to use such short periods.

Consistently beating over 3 year periods is more meaningful than having beat over one 3 year period. 5 year records are more meaningful than 3 years, 7 over 5, and 10 over 7.

In addition to good long term records, investors have to find someone who has the right process and a disciplined manner of applying it. They need to understand what the manager is doing, in layman’s terms, and believe in that methodology strongly enough to stay put when things look scary (and they will look scary at some point–just count on it!).

Most importantly, investors have to find someone they trust. A charlatan with the right process, discipline and convincing methodology will still rip you off.

Measuring long term performance is but one element in selecting an investment manager because investors must also judge the character of the person they are considering. I’m not saying it’s easy, but it is important.

(for full disclosure on performance calculations mentioned, please see my website; please note that my website won’t reflect year-end performance until 1/18/10)

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.

Advertisements