The World’s Most Expensive Hobby (Part 3)

Key Points

  • To invest wisely, you need to define a benchmark before you actually make any investment decisions.
  • Even if you have a benchmark in mind, an active investment philosophy brings a whole host of issues when it comes to tracking investment performance.
  • These issues ultimately obscure the true performance of active investors, which makes it very difficult to figure out if one is investing prudently or not.
  • This obscurity is what likely perpetuates an active investing philosophy; however, over time, this can lead sub-optimal investment performance for the average investor.

Measuring Success, Generally

We introduced Barber and Odean in Part 2 of this series in order to provide a high-level understanding of just how impactful excessive trading can be on investor returns. Over the course of his post, we’ll dig into the returns of an average investor as compared to a stated benchmark based upon further work from these two individuals. But before we get too far into their research, let’s discuss the importance of even having a benchmark, in general.

“A benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose.” —Investopedia

How do you measure if an investment is a good one? Or more specifically, why invest in one thing over another? Most people choose to make an investment in something because they have some sort of expectation of future profit. But after the investment is all said and done, how does one tell if the investment was actually a good choice?

One way is to consider if the investment lost money or not. However, astute investors understand that it’s more important to understand whether or not an investment did better than the next best alternative. And when it comes to making an active investing decision, the next best alternative is often a passive investment. For example, rather than buying a handful of stocks (say, IBM, Wal-Mart, and Coke), and investor could instead just invest in a passively managed S&P 500 Index fund. We highlighted this notion in when we discussed Opportunity Cost earlier in this series. The idea is that over time you’ll want to see how your handful of stocks did as compared to the S&P 500 Index as opposed to how much money you actually gained or lost on an absolute basis.

Measuring Success, Specially

However, as we’ve noted in the past, beating a given benchmark is not only about generating a higher return, but also the risk that you take along the way. As such, the ultimate goal of any investment is to maximize risk-adjusted returns such that you generate the highest return possible for the least amount of risk. Thus, in principle, you should aim for a higher risk-adjusted return than the benchmark can provide if you choose to invest actively.

“There is one important caveat to the notion that we live in a new economy, and that is human psychology . . . which appears essentially immutable.” –Alan Greenspan

Alan Greenspan
Chair of the U.S. Federal Reserve Board
Speech at the University of California at Berkeley
September 4, 1998

Furthermore, just because the S&P 500 Index is perhaps the most common benchmark, this doesn’t mean that it’s the best benchmark for you. Each individual has his or own level of risk tolerance and investment horizon, and thus each individual has his or own expectation of investment performance.

For example, a high-income generating young professional with little debt will likely have a high level of risk tolerance because this individual can stand a downturn in the markets given that he or she doesn’t need access to retirement savings for a long time. As such, this individual will likely choose a target benchmark that is more risky, but offers higher returns over the long-term, such as the S&P 500 Index.

Alternatively, a retiree with a mortgage and little savings that primarily lives off a modest pension supplemented by savings and Social Security will likely invest in capital preservation instruments, such as bonds or money market funds. These instruments provide a modest income stream, but with lower risk. As such a better benchmark for this individual will likely be cash or U.S. Treasuries.

Ex Post Facto, Not So Fast-o

Accordingly, the first step before even making an investment decision is to clearly define one’s benchmark. Note, that I said before. This is a critical point. A common mistake among investors is to evaluate an investment outcome without having a clear goal in mind. The concern here, is that it’s hard to pick a benchmark after the results are said and done.

Here’s why. Let’s say you have an extra $10k to invest, and you end up buying a classic car. Not wanting to damage your investment, you keep the car undriven and parked in a covered garage for ten years. You still take the time to keep the car in top shape by performing regular maintenance. And ten years later, you sell the classic car for $15k. At this point, you pat yourself on the back for having turned a profit.

But, was this really a wise investment? From your standpoint, you made a 50% profit. Not bad at all, it seems. But what’s your benchmark? If someone were to ask you this question after you sold the car, you might be tempted to tell yourself that you would have just left the money in cash. And you might have. But it’s hard to say. You might have bought bonds, you might have just taken an expensive family vacation. Memories are priceless after all, right?

Your financial advisor might suggest that your benchmark for these funds was the S&P 500 Index, but it’s really too hard to say at this point. For example, as we’ve suggested, the S&P 500 Index has performed exceptionally well over the past 10 years, returning over 10% a year over this period. So by comparison to this particular benchmark, you are in fact far behind. Of course, it gets even worse, if you factor in the storage and maintenance costs of the vehicle, but the big point is that had you invested in $10k in the market you might have earned over $18k over this same 10 year period.

Therefore, if you don’t know what you’re trying to beat, it’s very difficult to understand if you’ve made a good decision in the end. And that’s why choosing a benchmark from the beginning is so important.

Ruh Roh

Let’s say you do have a benchmark in mind that you chose before you begin investing your wealth. First off: great. You’re already ahead of the pack. But now on to an even bigger concern with managing an active investment philosophy. Your new concern is that tracking your actual performance is going to be very challenging, if not next to impossible.

Here’s why. Let’s use our classic car example above. Say your benchmark was the 10 year U.S. Treasury Bond. So your goal is to have more money at the end of 10 years than if you had invested $10k in Treasuries. However, as we’ve mentioned above, the amount of risk that you take along the way is important to understand. For example, you’ll want to know how much the price your car fluctuated by over the course of the ten-year period. This of course will be tricky to figure out.

Furthermore, you’ll want to understand the true financial impact of investing in the classic car. As I’ve mentioned above. You’ll need to consider all of the ancillary costs that come with investment. Renting a garage for ten years is not free; neither is the time you have to take to handle any maintenance issues; and of course there’s the cost of the maintenance issues as well. Further, there’s a period of time where you had the $10k saved up, but were still looking around for the classic car. Your $10k could have been invested over this period, but instead, you held on to cash given your liquidity needs for your impending purchase. All of this needs to get factored in. And of course, it’s all almost impossible to track accurately.

The simple truth is that you may never actually know the true amount of return that you actually generated from this investment; you may never actually know the true amount of risk that you took along the way; and you may never actually know how much you would have earned had you just passively invested in your benchmark.

All of these concerns point to an often overlooked issue with active investing in general. It’s the patent notion that you’ll likely never know if you’re doing a good job or not. It’s for this very reason that most active investors continue with type of investing, i.e., most don’t know what they’re giving up by this endeavour. And most never will.

With this in mind, and now that we’ve laid the groundwork, let’s now dig into Barber and Odean’s paper, “Trading Is Hazardous to Your Wealth” in Part 4 of this series. What we’ll soon find is as compared to a benchmark, the average active investor does not fair well at all. I know that most of you think you are better than the average (aren’t we all overconfident); nevertheless, I’m sure we can all learn a thing or two from these two individuals.