The Quarterly Report

  • The Quarterly Report
  • Fourth Quarter 2006
  • Chuck Osborne

Measuring Success

How do you know? To measure success you have to know what you are measuring against. All success is relative. We’ve all heard the story of the two hikers walking through the woods. They come across a very angry and hungry grizzly bear. The first hiker looks at the second hiker and asks, “What are you going to do?” The second hiker says, “I’m going to run.” The first hiker asks, “Do you really think you can out run a grizzly?” The second hiker responds, “I don’t have to out run the bear, I just have to out run you.”

Success is relative to your competition. The Ohio State Buckeyes thought they had the best team in college football, because they looked like world-beaters relative to the competition in the Big 10. On the other hand, the Florida Gators looked like a lucky team who won in spite of themselves playing in the SEC. However, after cruising to a 41-14 victory in the BCS Championship Game, it is now obvious that Florida had been measured against a much harder benchmark than Ohio State.

If it is that difficult to see who the best football team is, then how are you supposed to figure out how your investments are doing? Let’s break it down into steps. The First step is to actually calculate your total rate of return. If you are an Iron Capital client then this is pretty easy, because we show your total return on your statement. But for most investors this is not as simple as it might seem. If you are like most investors your portfolio is spread over multiple accounts and the statements you receive typically do not show the rate of return.

Most people I know look at their statements and if the account balance is up they are happy, and if the account balance is down, they are sad. However, they do not know their actual rate of return. Some are a little more analytical and they will look at each holding, and mentally note, “this one is up roughly 10%, that one is down,” etc. Perhaps they even have had one holding double or more, and they extrapolate from that how well they have done as a whole. William Goetzmann and Nadav Peles published a study on this subject in the Journal of Financial Research in 1997. Goetzmann and Peles asked a group of investors two basic questions: 1) What was the return of your portfolio last year? 2) By how much did you beat the market? On average the group overstated their returns by 6.22% and overstated their out-performance of the market by 4.62%. This overstatement is due to a condition that psychologists call cognitive dissonance.

Put simply, people want to have a positive self-image. Any information that damages that self-image is rejected, and if it can’t be rejected it is accommodated by a change in beliefs. For example, last week I had lunch with a colleague who informed me in certain terms that Ohio State would not only win but that they would win by a large margin. When I spoke to my colleague after the game, he started talking about the long break between the end of the season and the bowl games and rationalized that if the game had been played earlier it would have been different, etc. My friend can’t deny what happened but he can change his belief about the circumstances. Before the game the long break was not an issue, but now that the facts are in it must have been the issue, because it just isn’t possible that my friend could actually have been wrong. That is cognitive dissonance.

When investors suffer from cognitive dissonance they tend to remember their good investments and forget their poor choices, and as a result they overestimate their performance. This is what Goetzmann and Peles found. This also explains the often-quoted Dalbar study, which states that the average equity investor earned a 3.51% average annual return from 1984-2003 while the S&P 500 earned a 12.98% average annual return for the same period. That average investor probably believes his return was much higher, because he has blocked his bad investments out of his memory.

Nothing strips away cognitive dissonance like the brutal honesty of math. Calculating performance for one time period, say last year, is not that difficult. If you did not add or take out money from your portfolio, you simply take your ending balance (total of all accounts) minus your beginning balance then divide by the beginning balance. For example, if you ended with $1,157.90 and started with $1,000, your return was (1,157.9 – 1,000) / 1000 = 0.1579 or 15.79%. That is easy. However, if you are like most people then you did have cash flows into and/or out of your portfolio, and those must be adjusted in order to find your return. This is where the math gets tricky.

If you have a business calculator or know your way around an Excel spreadsheet you can calculate the internal rate of return (IRR). The problem is that this gives you a money or cash-weighted rate of return. In other words, your return is going to depend on when exactly these cash flows took place. Moreover, we are eventually going to compare this return to some benchmark, and the benchmark is not affected by these cash flows. Your relative success could be overstated or understated depending on when you put money into your portfolio and/or took it out. There is an important distinction here: when I refer to cash flows, I am not referring to the investment decision of investing in equity versus cash. These investment decisions are exactly what we are trying to measure. Instead, I am referring to actually adding additional funds to your total portfolio and/or taking funds out of your portfolio for spending needs.

What you need to do, and what both the CFA Institute and the SEC (the government agency not the football conference) require, is to measure your portfolio’s time-weighted return (TWR). TWRs are calculated by subtracting the beginning market value from the ending market value and then dividing by the beginning market value for each sub-period. A new sub-period begins each time there is a cash flow. The sub-period returns are then geometrically linked together to calculate the return for the entire period. Don’t worry, I am not about to try to explain calculating the geometric mean, but any investment adviser should be able to do this for you. If your adviser can’t calculate this then call us and we will be glad to help you.

Once you have calculated your actual total return, you are ready for step two. The second step is to know the benchmark by which you should be measured. The S&P 500 is the most popular market proxy for stocks, and if you are investing in stocks and bonds you probably need to blend that benchmark with a bond benchmark like the Lehman Brothers Aggregate Bond Index. Both can be found on web sites such as However, your real benchmark return should be the minimum required return to achieve your investment goals. Calculating that is a topic for another newsletter.

Wishing you investment success,


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

The economy is slowing? For most of the quarter economists have been saying the economy is slowing down. Third quarter GDP came in originally at 1.6%, was revised to 2.2% and then revised again to 2%. This uncertainty comes from the real mixed bag of economic news. Housing remains bad and manufacturing dipped in the fourth quarter. The December jobs report showed losses in construction and manufacturing jobs, however over 75% of Americans now work in the service economy where job gains were strong. Overall we gained 167,000 jobs in December and the unemployment remained 4.5%. Perhaps more importantly wage growth now stands at 4.2% up from 4% last quarter.

Consumers did show up in December. Retail same store sales came in up a surprising 5.4% for the month after being up 3.5% in November. The story is not as good for the nation’s largest retailer Wal-Mart where sales were only up 1.3%. Our favorite retailer, American Eagle Outfitters, saw same store sales rise 13%, while the GAP saw sales drop 9%.

We believe GDP will grow at a rate of 2.5% in 2007, with most of the growth coming in the second half of the year. This is respectable growth but it is slower than the 3.2% in 2005 and the estimated 3.3% in 2006.

The global economy appears to be slowing as well. The European Union is expected to grow at a 2.1% rate next year down from 3% this year. Central banks continue to raise rates world wide, the latest being the Bank of England, who increased rates by 0.25% up to 5.25%.

Review of Market

Markets were up strongly for the fourth quarter. The S&P 500 was up 6.7% for the quarter ending the year up 15.79%. Small stocks surprisingly outperformed. The Russell 2000 index was up 8.9% for the quarter and ended up 18.37% for the year. Value outperformed Growth with the Russell 1000 Value index, which represents large cap value stocks, being up 8.00% vs. the Russell 1000 Growth index which was up 5.93%.

The Fed remained on hold leaving the fed funds rate at 5.25% and long-term rates fell from 4.63% to 4.61%. The yield curve remains downward sloping, indicating that the market expects short term rates to be lower in the future. The Lehman Brothers US Aggregate Bond Index was up a modest 1.24% for the quarter. High yield bonds remained strong with the Merrill Lynch High Yield Master Index up 4.17% for the quarter and up 11.64 % for the year.

International stocks remained strong during the quarter. The MSCI EAFE index, a proxy for developed international equity markets, rose 10.40% and ended up 26.86% for the year. Foreign emerging markets ended a volatile year up 22.05% for the quarter and 41.59% for the year.

Market Forecast

We have raised our estimate for 2007. The S&P 500 will be up 10%, although the market as a whole will be more modest. Equities remain more attractive than fixed income with interest rates still very low by historical standards.

In February of 2000 the average price to earnings ratio (P/E) for the largest companies in the US market were in the mid to high 20’s, while the average P/E for the smallest companies were right at 10. Today we are almost in the exact opposite position. The smallest companies in the market have an average P/E of more than 20 while the largest companies sit around 11-12. Large cap stocks are far more attractive, and traditional growth industries are especially attractive as Value has outperformed now for almost 7 years.

Foreign equities remain attractive although the valuation difference has closed some. Growth is slowing in Europe and liquidity should start to dry up for the emerging economies. Emerging market strength often goes hand in hand with commodity prices, which peaked in May after a strong 6 year run. Asia remains the bright spot although China may be overplayed at this point. Money is made and lost when the markets are surprise, and based on current sentiment the only possible surprise in China would be a negative surprise. The continuing weakness of the dollar should help US investors in developed foreign markets.

The Fed remained paused. However, we do not see interest rates actually dropping anytime soon, with real rates still being historically low. In fact, we would not be surprised if the fed had to raise rates again before finally easing. We continue to expect a current yield return from fixed income with little capital gain or loss from interest rate movements.