A Better Approach to Evaluating Investment Performance

0989224I speak a lot on the topic of investor behavior. I provide education and training for financial advisors and thanks to a contract this year with a major financial institution, I am presenting to many retail investors. One of the greatest benefits of this work is hearing others’ experience, aspirations and frustrations (from both retail investors and financial professionals). Over the past year a common theme has emerged: Diversified investors are frustrated – they have underperformed the major US indices for several years now.

Reviewing investment performance is somewhat of a rite of passage when investing. Whether doing it alone or with a financial professional, everyone wants to know how they did over a specified period. Oftentimes those results influence how we feel, and may also influence us to make changes to our current investment strategy based on the prior period’s outcome. Because of this, it is important that we evaluate our performance appropriately.

Theory of Financial Relativity

Many times our decisions and responses to situations are not based on the results of a specific outcome, rather on the outcome relative to something else. When it comes to investing, that something else may be past performance or performance obtained by another person or index. If we did relatively better than another individual or index, we feel good. If we did relatively poorly, we feel bad.

Let’s say one year from now you open your 2015 annual investment statement and see that your return on investments was 5.75% for the year. Would you be happy? For most people the immediate response is “it depends”. What if the stock market was up 28% during the same time period? What if the stock market was down 17%? Your degree of satisfaction (or discontent) is based on how you did compared to something else. The brain is a horrible judge of absolute values, but is excellent at judging values relative to something else.

The Art of Framing
The way a question or situation is framed (worded or illustrated) can have a significant influence on our response. The facts can be completely the same, but how we perceive the facts and our opinion about them can be altered depending on how the information is presented. The same facts can be framed in either a positive or negative way.

Consider the findings from studies in which the responses changed based on how the information was presented (framed), even though the net result was the same:

1) More people registered early for a program when a penalty was assessed for missing the deadline than when individuals were offered a discount for early registration.

2) Economic policy was viewed more favorably when associated with an increase in the employment rate rather than a decrease in the unemployment rate

3) Respondents preferred a medical treatment when it was framed positively (lives saved), but didn’t like the same treatment when it was framed negatively (number of deaths) even though the net result was exactly the same

Decisions are largely influenced by how something is framed, including investment decisions.

Framing Investment Performance

Screen Shot 2015-03-07 at 2.17.31 PMOne of the more difficult challenges when it comes to evaluating investment performance is doing so during a prolonged bull market. Returns may be positive, but not “good enough” for diversified investors. Rather than feeling content for positive performance, investors may be disappointed. During bull markets diversified investors may regret not having more assets in stocks, and may be influenced to make a change. Investors often compare their performance to other investors and to stock indices. In fact, many brokerage statements will show the performance of major stock indices along side the investors’ performance, inviting a comparison of the two. Most investors know that it is better to buy low than to buy high. But we are buying high when we invest in what did well yesterday. It is best to take a step back and have a reality check. The Investor Preference Review to the right may help you.

Safety vs. Risk

Investors need to be reminded of what is more important to them in investing, making a ton of money in a short period of time or eventually reaching their financial goals. Diversified investors often want peace of mind and greater surety they will reach their goals, that’s why they are diversified. Yet, after witnessing significant gains any investor could be influenced to abandon the diversified approach. They key is to have investors remember how important peace of mind is to them when investing.

Review Goals & Objectives

Most people invest with a specific goal in mind, such as retirement or to put the kids through college. But after significant market gains, investors often supersede the long-term goal with a focus on relative performance. The goal becomes “do better than the market”, or at least to do as well as the market. This needs to be re-framed correctly. Investors should remind themselves of their initial (and continuous) goals for investing.

Make Valid Comparisons

Since we know the brain needs to compare performance to something else, we want to be sure it is being compared with the right perspective, or frame of reference. Investors often compare their performance to an index, such as the S&P 500. This can be dangerous. An index does not retire, does not sleep at night and has an infinite time horizon. So should we really be comparing ourselves to a benchmark that doesn’t have the same goals or portfolio constraints? That is like comparing apples to oranges. Investors need to recognize that an index is not representative of themselves, nor their goals.

Final Thought

Framing can be a very powerful tool to help you maintain the proper perspective. When you create your financial plan, you have the right frame. But external influences, such as significant market changes, may cause you to re-frame your perspective. Investors should re-frame the situations back to the realities of investing and their personal goals before making any significant changes to their investment plan or portfolio.


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