The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
“…the only thing we have to fear is fear itself…”
“You should know what you own and know why you own it.”
There is only one way to get truly independent advice…
Find out what the actual time-weighted return of your total portfolio really is…
How do you measure success? Success can be measured in countless ways, and if this were a deep, meaningful discussion about the quality of life we could talk about success in your relationships, your marriage, your spiritual life, etc. Thankfully, this is an investment newsletter and our measure of success is much easier to get our arms around…or is it?
“Can’t you see what is happening? Potter isn’t selling, Potter is buying and all because we are panicking and he isn’t.” – George Bailey (Jimmy Stewart), It’s a Wonderful Life.
This is one of my favorite quotes from one of my favorite Christmas movies. George Bailey and his new bride are on the way out of town for their honeymoon when they see a run on the bank. They give up their honeymoon budget to save the Bailey Building and Loan during the depression.
Fear and Greed: these are the emotions of the marketplace. Fear gripped the nation during the Great Depression and the runs on the bank that were illustrated in the classic film were commonplace. Franklin D. Roosevelt, in his first inaugural address on March 4, 1933, uttered these famous words, “So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning unjustified terror which paralyzes needed efforts to convert retreat into advance.” I would guess that most of you recognize that quote. I would also guess that most of you did not know that this was given in a speech in 1933, long before the onset of World War II, and FDR was not talking about facing Nazis or the Japanese. Later in the same speech he goes on to say, “In such a spirit on my part and on yours, we face our common difficulties. They concern, thank God, only material things.”
FDR was talking about economic fear. He was talking about the kind of fear we see today on Wall Street. Irrational, short-sighted fear. There is of course a difference between now and then. Now, we are just a few short months from all-time record highs on Wall Street, then we were suffering through the worst bear market of all time. Now we have 5% unemployment which is incredibly low on historic basis, then unemployment was rampant. Now we have had just a few mortgage companies go out of business, then more than 4000 banks went under in the first two months of 1933 alone. In other words, they actually had cause for fear; we do not.
The problem with fear and its evil twin greed for that matter is that it is almost always short-sighted. Wall Street has always suffered from this disease, but in recent years it has gotten much worse. The CFA Institute has even given it a name, Short-Termism. Short-termism results in the permanent destruction of wealth, or at least the permanent transfer of wealth. This was the conclusion drawn by Jack Gray, investment strategist at the firm of Grantham, Mayo, Van Otterloo and Company in Sydney, Australia. Gray presented his findings at the CFA Institute’s 2006 annual conference.
Gray points out that from 1945 to 2005 the average turnover of US equity mutual funds has gone from just over 20% to over 100%. In 2005 the average mutual fund held a stock for no more than 9 months. The results speak for themselves. Jack Bogle, founder of Vanguard, points out in his research that from 1983 to 2003 the average mutual fund had an average annual return of 10%, while the S&P 500 had an average annual return of 13%. The actual investor did even worse, with a 6% return according to Bogle. Not only are the mutual fund managers short-term focused with 9 month holding periods, but the mutual fund investor was also short-term focused holding their investment for only 2 years. Let me put this in perspective for you. If you invested $100,000 in a tax free account in 1983 and got the 13% return from the S&P 500, in 2003 you would have accumulated $1,152,309. If you got the 10% return from an average mutual fund you would have accumulated $672,750, and the 6% return of the average investor would net only $320,714. Those differences in percentage returns may not seem that great, but the difference in resulting wealth is huge.
Much of that wealth destruction can be blamed on shorttermism. Gray conducted a poll to determine who was responsible for short-termism and 89% of respondents selected the media. Mutual fund managers know they can get on the cover of Money magazine, or one of the other financial tabloids, only if they post huge short-term returns. You as an investor may have a time horizon of 10, 20 or even 30 years but no one in the financial system shares that view. Starting with government regulators, who are either political appointees whose time may be short, or are young attorneys padding the resume to make the big move to a Wall Street firm. Their time horizon may be 3 years if you are lucky. Investment managers are judged monthly by their institutional clients. The media may have a time horizon as short as hourly. The good people at CNBC want to know what is going to happen in the next 15 minutes. Finally, traders and hedge fund managers have the shortest time horizons of all. The system is heavily biased towards the short-term which causes what Gray refers to as a substantial principal-agency horizon misfit.
This leads us to the newly popular momentum investing fad, which is the quintessential form of short-termism. Momentum investors buy what has gone up and sell what has gone down. Momentum investing can be a self-fulfilling process as prices go up or down not because they should but because momentum carries them in that direction. This private gain comes at a public loss as the market ceases to be a mechanism to allocate capital efficiently in order to maximize total economic output, and becomes instead a ponzi scheme leading to bubble after bubble.
I have often been asked how it is that Warren Buffett is able to do what he does, and my answer is simple. He never has to answer to clients or the media. He has the benefit of being able to think long-term. Long-termism has three distinct advantages to short-termism. First, there is better predictability. It is nearly impossible to accurately predict what the market will do next week or next month. However, in the long-run the market tends to get valuations right, therefore assets that are over-valued currently will tend to go down while assets that are under-valued currently will tend to go up. In fact Bill Miller of Legg Mason has suggested that the current short-termism epidemic has actually caused what he referred to as a “long-term arbitrage opportunity.” For investors who are brave enough to move against the grain, great long-term gains can be earned. However, the pull of short-termism is great. In late October, I was asked by a friend what we thought of the current market conditions and where we saw opportunities. I told him that we saw great opportunities in banks that have been overly beaten down by Wall Street short-termers. I saw my friend again over Christmas, and he told me that our bank idea had not turned out that well. I had to laugh. It had been less than two months, we won’t know how it “turns out” for several years. We are investing here, not speculating.
Long-termism also leads to lower cost because of lower turnover, and lower risk of real investment losses. As we discussed last quarter, long-term investors are owners who are less concerned about price fluctuations than they are about the fundamental health of the companies they own.
There is a scene later on in It’s a Wonderful Life when Potter offers George Bailey a job. Potter, singing George’s praises, remembers the depression and says that George and he were the only two who didn’t panic. “You saved the Building and Loan, and I saved the rest.” George responds, “…most say you stole the rest.” Potter retorts, “The jealous ones say that…” In our current environment gripped with fear of the short-term most will panic but we will not. A few years from now when we look at the gains we have achieved from this point, some may suggest that we stole them, but those will be the jealous people who didn’t have the courage it takes to think past this current crisis.
CHUCK OSBORNE, CFA, Managing Director
WHERE HAVE ALL THE OWNERS GONE? Do you miss the days when you went to the hardware store and the owner was standing behind the counter? Or what about going out to eat? Certainly there are some good chain restaurants, but my favorites are still places where the owner is on site and comes by your table to see how everything is going. Owners make a big difference.
If you don’t believe me look at any franchised business. Let’s take Holiday Inn for example. I travel a lot and have stayed in all sorts of hotels, and I can tell you that some Holiday Inn’s are fantastic, and others are a little scary. It all depends on the individual owner. Holiday Inn’s corporate office knows this. They have found that one of the main reasons their market share of hotel nights has fallen is because the frequent traveler never knows what they are going to get from one Holiday Inn to the next. As a result, Holiday Inn is weeding out bad owners from their system. OWNERS MATTER. So who owns corporate America?
Do you know? Do you care? I argue that you should. Being in this business I always hear about how mad people are about CEO compensation, ethical breaches and yes, even six years later, I still get an earful about Enron. I usually just listen politely and agree with most of what people are saying. Then I might ask how they invest their money, and I hear things like, ‘I have it all in index funds.’ More and more, they tell me about this great hedge fund, or about the virtues of commodities and of course the new ETF they just bought. What I never hear anymore is something like, “I own Coke.” Somewhere along the line, Wall Street seems to have convinced people that they should stop investing in companies and start investing in markets. John Boggle is probably as responsible for this as anyone else. If you don’t recognize the name, Mr. Boggle is the founder of Vanguard, the indexing king of the mutual fund world. He popularized the notion that most active money managers don’t beat the market and therefore one should simply invest in the market and not try to pick companies. In the boom years of the 1990s, this notion became conventional wisdom.
Of course, like most conventional wisdom, there is some truth to what Mr. Boggle suggests. Especially in very efficient markets and in markets that are being driven by irrational forces. For example, in the late 1990s when most active managers were avoiding technology stocks due to their valuations, the S&P 500 looked unbeatable. In July of 1997 less than 6% of active managers benchmarked to the S&P 500 were outperforming the index for the three year period that had just ended. Contrast that to January of 1982, when 81% of active managers outperformed the “market.” Thirty-five percent of managers beat the S&P 500 over three year periods on average. So, like most conventional wisdom, it isn’t completely true.
There is of course one investor who is known for his ability to beat the market. Warren Buffett is not only the second wealthiest man in America, but also the most famous of all investors. The annual report of his company, Berkshire Hathaway, is a must-read for anyone interested in investing. Buffett made his name by investing in the stocks of publicly traded companies, and his firm has grown to the point where he now mainly buys companies in their entirety. However, he still runs the stock portfolio, and this is where I think the greatest lessons lie for average investors who don’t have a few billion dollars at hand. I was reading the 2006 Berkshire Hathaway Annual Report earlier this year, and something jumped out at me: Buffett went through the entire discussion of the stock portfolio without once mentioning what had happened to the price of any of the individual stocks he owns. He talked about the various companies’ earnings and cash flow, and he spent the greatest amount of time talking about the CEOs and how talented they were. Not once did he mention whether the price of the stocks had gone up or down, or by how much.
I don’t know why this jumped out at me this year, because it is nothing new for Buffett. He has many famous quotes about how important it is to ignore the market, but for some reason this year it really struck a chord with me. This man does not invest in the market, he owns companies. This is at least part of what has made him so successful.
Contrary to his legend, he is not alone either. There are actually several legendary investors who can rival Buffett; they just don’t have his fame or his personal wealth because unlike Buffett, they mainly invested other people’s money – people like Buffett’s mentor, Benjamin Graham; Philip Fisher; Peter Lynch; Bill Miller; Ralph Wanger; and more. There is actually a long list. Each of these investors is unique. Graham is the father of security analysis and of what we today call value investing. Fisher is the father of what we now call growth investing. Peter Lynch ran portfolios with hundreds of stocks, while Bill Miller has never owned more than 40 or 50 stocks. Ralph Wanger was a small stock specialist.
Very different men with very different approaches, yet they all have two things in common. First, they were/are owners of companies. Good companies with solid fundamentals and good managers. Second, they bought these companies at good prices, then held on to those companies for a long time. It is that simple. You are probably thinking, “It can’t be that simple.” Well in the words of Buffett himself, “There seems to be some perverse human characteristic that likes to make easy things difficult. It’s likely to continue that way. Ships sail around the world, but the Flat Earth Society will flourish.”
Michael Mauboussin in his book, More Than You Know, looked at the characteristics of mutual funds that had beaten the market over the decade that ended in 2004. Those funds had an average portfolio turnover of 27% versus the average equity mutual fund, which had a turnover rate of 112%. That means the average mutual fund manager owned the stocks in his portfolio for less than a year, while the average manager who actually outperformed owned his stocks for an average of four years. Most money managers did not own companies, and instead were simply “renting” the stock. The successful money managers were owners.
There are other benefits to owning companies as well. When you own stock in a company, you have a vote – a voice in what direction the company decides to go. Granted, for the average investor your voice may be one of the quieter voices in the room, but it still exists. If you don’t like how the current management is running the company you can voice that opposition, and if there are enough other investors out there who share your concerns, you can effect change. If that change doesn’t occur you can sell your shares before the consequences of management’s actions come to roost. For example, many investors get upset when companies fire their CEO and pay them millions in severance. However, the owner who is actively paying attention knows that the real mistakes happen when that severance is promised upon hiring the CEO, not when it is paid out.
Ownership also tends to settle the nerves in the face of market turmoil. When stock prices drop, traders tend to panic, while owners ask themselves, “Has something really changed with this business, or is this just short-term market silliness?” Most of the time it is just silliness. To a large extent, this explains why owners do better in the long run.
I hear lots of stories about exciting investment products like hedge funds that promise huge returns with little risk. However, I have never met anyone who has gotten rich by investing in a hedge fund. If you have, please ask them to give me a call – I would like to meet that person, but I won’t be holding my breath. On the other hand, I have met lots of people who have come to me for advice in how to manage the large sums of money they have made from companies they invested in 20, 30 or even 50 years ago. Ownership works.
At Iron Capital, we believe in ownership. We agree with Peter Lynch when he said, “You should know what you own and know why you own it.” We use that philosophy not only in the equities our clients own directly, but also when picking mutual fund managers. We like managers who own companies, who understand the long-term strategy of a business, and who are not just guessing about what the stock will do over the next few months. This strategy doesn’t always outperform in every short-term interval, but it does in the long run, and in the end that is the only run that really matters.
CHUCK OSBORNE, CFA, Managing Director
~Stop Investing in The Market. Own Companies Instead.
“When in the course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the power of earth, the separate and equal station to which the laws of nature and of nature’s god entitle them, a decent respect to the opinions of mankink requires that they should declare the causes which impel them to the separation . We hold these trutths to be self-evident, that all men are created equal, that they are endowed by their creator with certain unalienable rights, that amonth these are life, liberty and the pursuit of happiness…”
With these words written by young Thomas Jefferson (and a few edits from Benjamin Franklin who didn’t think the document important enough to write himself) our founding fathers declared our independence from Great Britain and gave birth to our nation.
Independence is a trait that Americans value highly. It is closely related to our favorite value which is Freedom. You cannot be truly free if you are not first truly independent. In 2003 when I first envisioned the business plan that became Iron Capital the most important factor was that we had to maintain perfect independence. We adopted the tagline, “Your gateway to independent investment advice”. We placed independence first among our core values, with the guiding belief that one cannot serve two masters.
Unfortunately, the word “independent” is beginning to lose its true meaning. Earlier this year I saw a commercial on TV from Smith Barney claiming that their financial advisers were “independent”. I only saw the ad a few times so I believe someone may have wised up and pulled it, but Smith Barney is not alone. AG Edwards has long claimed that their advisers give “un-biased” advice. Raymond James has recently joined in as well. They all want to claim independence because they all know that is what their customers really want. If someone in the marketing department can make an argument for them being somewhat independent, then they will run with it.
The problem is that for most people the inner workings of the investment industry remain a mystery. The average investor has no idea if the advice he is getting is truly independent or if it is actually a sales pitch masked to look like advice. So I am going to try to shed some light on the industry and on how you can guarantee the advice you are getting is truly independent.
To understand the industry you must understand the roles played. The first role is what we refer to as custody. If you are going to invest your hardearned dollars, those dollars, and the investments you buy with them, have to be held somewhere. Custodian, as the name implies, is the person who actually holds the money. A custodian can be a bank, a trust company, or a broker/dealer. They hold your money and assure other parties in your financial dealings that you will pay for the various investments you wish to purchase. They are highly regulated but by different government agencies.
Once your money is at the custodian you can then transact – buy and or sell stocks, bonds, mutual funds etc. The role of transacting in the financial markets is done primarily through broker/dealers. Broker/dealers have two functions, they work primarily as a store (dealer) which has merchandise on its shelves that it wishes to sell to its customers. If what the customer wants is not on the shelf, then the salesperson can order it for them (broker), assuming they have the ability to sell the product in the first place. Broker/dealers, like retail stores, have professionals in their home offices who determine what should be on the shelves. They also have sales people in their stores who would be glad to find you a mutual fund or municipal bond in your size. They now even have computer-generated fitting rooms where you can see what your portfolio would look like in this season’s latest asset allocation models. Broker/ dealers are registered with the SEC and the National Association of Securities Dealers (NASD) and their sales people must be registered as their representatives. Registered representative is the official legal title of “financial advisers”. They are regisistered with the NASD, and they represent their broker/ dealer. They are salespeople in a store.
When you walk into a GAP clothing store the salesperson may be interested in fashion and design, but she has not designed or made any of the products on the shelf. That is left to professionals you never get to meet. The same is true if you walk into Smith Barney or UBS. The salesperson may be interested in investing, and may know more than you do, but they are not investment professionals. They are not trained to be investment professionals; they are trained to sell. There is not a financial advisor (registered representative) in the world who is judged and/or compensated by his employer (broker/dealer) based on how his client’s investment portfolios have performed. They are judged and compensated the way all sales people are judged and compensated: by how much product they have sold.
Of course not all stores are the same, and this is true for broker/dealers as well. Some stores like GAP and Old Navy sell products they make themselves under their own brand, while other stores like Macy’s or JC Penney sell many brands. This is how some broker/dealers claim to be independent, because they don’t sell their own branded products. This would be similar to someone at Macy’s telling you that they were independent because they carry multiple brands. I have also never been told by someone at Macy’s that I would look better in a suit from Brooks Brothers. Likewise, no registered representative will ever advise you to buy a product that their broker/dealer doesn’t carry. To assure this, broker/dealers have made doing so against NASD regulations. It’s called “selling away”.
There is only one way to get truly independent advice, and that is to separate advice from custody and from the transactions. Never allow your adviser to have custody of your assets. If everyone would follow that simple rule we would eliminate almost every possible investment scam. Never take investment advice from a registered representative. Fortunately for the average investor, it is easy to find out if your adviser is really a salesperson. Look at their business card, if they are a salesperson then the phrase “securities offered through…” will appear in fine print on the bottom or sometimes on the back. If it is there, than the advice you are getting is conflicted.
This is when most people get bent out of shape. They say, “my adviser is a good person and she would never take advantage of me or give me bad advice.” And they would be right. Most advisers, just like most retail store sales people, mean well and would not purposely harm any of their clients. But they are not the people designing the products on the shelf. The people who design and manufacture the jeans at GAP don’t know you, they will never meet you and they don’t think about you when they decide to use thinner fabric that doesn’t cost them as much and wears out faster, making you buy jeans more often. Similarly, the investment professionals in back offices don’t know you, nor do they often think about you when they design profitable products and negotiate revenue sharing for shelf space in their store. I know this because I was one of them.
Last quarter I relayed a story about Richard Bernstein, the Chief Investment Strategist for Merrill Lynch. He was speaking at a dinner for investment professionals in Atlanta and he told a story about Brazilian Highway Bonds. He told the story as a joke. It is a common joke among investment professionals, the punch line is always, “what idiot is going to buy this?” Well, Merrill Lynch customers bought those Brazilian Highway Bonds, and I just hope they get some of their money back. They were sold because the underwriter was just doing his job, getting the product on the shelf. The adviser was told to sell the product, and assuming his company wouldn’t underwrite something recklessly he offered these bonds to clients who I am sure loved the promised payments which had to be high. The problem is not that any of these people are bad, the problem is that the system is bad.
Our founding fathers did not declare independence because King George was a bad King. They declared independence because monarchy is a bad system of government, and they replaced it not with a new King but with a Republic with checks and balances and a separation of powers. Similarly, Iron Capital and the hundreds of other firms like ours spreading throughout the country do not offer a better solution because we are better more moral people than your old adviser. We offer a better solution because we offer a better structure with checks and balances and a separation of powers. We are your gateway to truly independent investment advice.
CHUCK OSBORNE, CFA, Managing Director
My wife’s favorite movie is When Harry Met Sally. We own it on VHS and DVD and I’m sure we will own it on whatever platform comes next. In one scene, Sally (Meg Ryan) is berating Harry (Billy Crystal) over lunch for a string of meaningless relationships and onenight stands. Harry tries to defend himself by suggesting that his dates have all “had a good time.” Then Sally suggests that Harry’s dates may have only been pretending to have a good time. Harry denies that anyone could fool him, and Sally reminds him that it is simple math: most women have at some point pretended to be having a good time, while no man believes that this has ever happened to him. Then Sally demonstrates faking a good time, which is followed by the most famous line in the movie, in which a customer at another table says, “I’ll have what she’s having.”
I was reminded of this scene twice in this quarter. The first time was when one of my loyal readers pointed out that two quarters in a row I had referenced the same study from DALBAR, which says the average equity investor has gotten only a 3.51% average annual return over the last 20 years. Thanks to this insightful observation I have now referenced it three quarters in a row in the hopes I can get a second reader to pay attention. I was also reminded of this when visiting one of my institutional clients. This client has more than 16,000 participants in their 401(k) plan and their record keeper helped us with a study that showed that 91% of those participants are underperforming the professionally managed portfolios available to them. There are a lot of Harry’s out there who accept the fact that most people need help, but surely it couldn’t happen to them. Well, as Sally said, it is simple math. That is why it is so important that you take my advice from last quarter and find out what the actual time-weighted return of your total portfolio really is. If you don’t really know what return you are getting it is easy to fool yourself into thinking that you are not part of the 91%. That the average return numbers don’t apply to me, they only apply to those average people.
Once you do know what your return is then you have to compare it to something meaningful. You need a benchmark. Most people use some sort of market benchmark, such as the S&P 500. Standard & Poors (S&P) has a committee that selects 500 of the most prominent companies in the US that it believes best represent the entire economy. The index tracks the movement of the stock prices of those 500 companies weighted by their respective market capitalization. In other words, larger companies have a greater impact than smaller companies. There is nothing wrong with using market indices to judge your portfolio’s performance. We use them ourselves to make sure we are doing a good job for our clients. I would suggest that this is the best way to judge professional money managers. (The S&P 500 is not always the best index to use when judging a manager but that is another subject) However, market indices are not the best measure for you to use for your personal purposes. We suggest that investors need to calculate their personal required return. What rate of return do you need to achieve in order to reach your investment goals? Your portfolio should then be managed in a fashion that gives you the greatest probability of achieving those goals.
This concept is exactly what we mean when we say that we are bringing institutional discipline to our individual clients. Institutional investors are pension funds, endowments and foundations. If you were a company and your portfolio was a pension fund, you would hire an actuary who would calculate what rate of return you must achieve over time in order to pay out all the retirement benefits that you have promised to your employees. You would, or at least should, then manage the assets in a way that best covered your liability.
A good example of this is American Airlines. They just won the Best Corporate Plan Sponsor of the year award from PlanSponsor Magazine. They have been able to maintain their pension plan while most other airlines have been using bankruptcy courts to get out of the promises that they once made to their employees. What was the difference at American Airlines? While other pension plans were trying to outperform the market in the late 1990’s American was focused on achieving their required rate of return. This meant that while other pension plans were buying high-flying tech companies at valuations that no prudent investor could ever justify, William Quinn, who manages the American Airline pension fund was sticking to investment basics. He took a lot of heat then, but now we can see how it turned out. Adriana Posada, who works for Quinn, says, “One thing we have never done is jump on the bandwagon with everyone else. It has served the plan well.” It can also serve you well.
Many investors we talk to understand the concept of required rate of return when they are saving for retirement. If I contribute X% of my salary to my 401(k) and get X% return on average than I will have enough to money to be able to retire comfortably. What they don’t understand is that this concept goes on into retirement as well.
Just as with the pension fund, you need to manage your portfolio in retirement much the same way you did when you were working. In retirement the mistakes tend to be different. Younger investors try to jump on the bandwagon and get rich quick, which usually leads to disaster. Retirees usually don’t do this. They are too wise to make those mistakes. They make all new ones.
The most common mistake we see in retirees is an obsession with producing income. They feel that because they are retired they must have a portfolio that produces income, as opposed to returns from capital gains. They confuse income with safety and capital gains with risk.
Earlier this year I was at a dinner with Richard Bernstein, the Chief Investment Strategist for Merrill Lynch. He told a story about how Merrill had underwritten Brazilian Highway Bonds. The bonds were sold in what they refer to as tranches or blocks, with each tranche representing a section of highway. The bondholders would be paid back through tolls collected on the highway. They were selling tranche seven which represented the seventh section of the highway. There was no guarantee that the sixth or eighth section of highway would ever be built, nor was there a guarantee that there would not be a free road running parallel to this toll road. Yet, they sold out in a day. Retirees are obsessed with income-producing securities and in this low interest rate, low dividend environment they are unknowingly taking on entirely too much risk in order to get that income.
Retirees need to think in terms of building a portfolio that will maximize the probability of achieving the required return throughout their retirement. For example, if a retiree needs 6% of her portfolio as income and believes inflation will average 3%, then she needs to get a 9% return (6% income + 3% for inflation). She should build a portfolio that maximizes that probability with the least amount of risk. That is what we do for our clients.
It doesn’t matter if you are saving for retirement or already there. The right benchmark for your portfolio is your personal required rate of return.
CHUCK OSBORNE, CFA, Managing Director
~The Right Benchmark
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 Morningstar.com. 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