Measuring Investment Success… the Smart Way
We’ve all heard from a neighbour, friend or colleague after they’ve made an impressive investment. Proudly boasting about a recent purchase of Shopify, gold bullion, or maybe Tesla, ably raking in double-digit returns. When asked about their impressive foresight, the response is often dismissive “I just knew it was a good buy” - obviously referencing their super-power investment sense. Or they provide, in perfect hindsight, a suspiciously-specific record of all that is now known to have driven the investment’s past success. It’s Nostradamus-like really.
Of course, we know these abilities don’t exist, yet it’s natural to feel a spark of envy over another’s profits. Why couldn’t I, or my investment advisor, achieve this kind of performance? Why am I still in a seemingly boring, well-diversified portfolio rather than simply picking the big winners?
The truth is, if your portfolio is assessed according to a more relevant metric, the risk-adjusted return, with all costs considered, over a reasonable timeline, it’s highly likely that you have indeed outperformed your clairvoyant acquaintance. At the very least, you’re almost certainly making smarter financial decisions.
Comparing a well-diversified portfolio to a highly-concentrated, highly-volatile portfolio is clearly not apples-to-apples because you’re not accounting for what’s truly at risk. That is, the unrealized value that could disappear over a given timeline. Think Nortel, Enron, Sino-Forest, Bre-X, Lehman … the list goes on and on. Investors often suffer from selective memory when discussing past investments like these.
Don’t get me wrong. Having a ‘risky’ portfolio may be part and parcel of your long-term financial plan. In that case, risk is fine, providing a) you have the tolerance for it, and b) you’re being adequately compensated for it with investment growth. It’s of course because of ‘b’ that risk-adjusted return becomes such an important measure.
This risk-return relationship is at the heart of modern portfolio theory. With any given amount of risk there should be a corresponding expected return (the efficiency frontier). If you’re getting less than this expected return, your portfolio is considered inefficient, and you have theoretically underperformed. Increase diversification (to a point), and you increase your chance of getting better returns for a given level of risk. This is why over-concentrated portfolios tend to have poor relative long-term risk-adjusted performance. Perhaps you’ll get away with a risky bet or two, and you’ll certainly enjoy boasting about it. But, lacking true super-powers and prophetic abilities, statistics inevitably prevail. So, your neighbor did really well with Bitcoin. Holding that in their portfolio didn’t make them a smart investor. This is a common cognitive vulnerability known as the ‘outcome bias.’
So, how do you track this better metric? Unfortunately, measuring true value at risk (VaR), can be very complicated for an investment portfolio, so most default to commonly accepted and published alternatives such as the Sharpe Ratio, Sortino Ratio, or Treynor Ratio. All of these measure the return relative to some form of risk, and none of them are perfect. But, if the alternative is calculating ‘total return’ and comparing against a benchmark, you’re simply ignoring a crucial attribute of your portfolio - risk.
How to adequately diversify is a subject all its own for another article, and it’s unfortunately not a single solution but rather an important factor in your complete portfolio strategy. Other risks include currency management, inflation, interest rates, geopolitical or foreign factors, liquidity, credit, reinvestment, event (horizon) risk, longevity, and more… You can see why thoughtful money management becomes important.
So, when your acquaintance proudly boasts of their short-term success, feel free to ask how they factor in risk and cost. And when you haven’t heard from them in a while, it’s fair to assume statistics are having their day.