Absolute short term investment returns have little decision making value
At the end of each quarter, the media focuses a lot of attention on the absolute investment returns achieved by fund managers, both of super funds and other managed investments.
They tend to get very excited when those returns are high (with term deposit rates often an implied benchmark) and suggest the fund management industry is a collection of geniuses. However, when returns are low or negative, the industry is painted as a bunch of overpaid incompetents that the amateur, do-it-yourself investor could easily outperform.
The reality is that over the short term the absolute returns of investment portfolios have very little informational or decision-making value. Investment returns are the outcomes of the process that generates them. You can’t directly do anything about returns. You can only influence or change the inputs that drive those returns.
It’s the same as, for example, Olympic swimmers who win silver medals. Wishing they won the gold medal won’t, of itself, get them any closer to winning it next time. It is their process that they need to examine – only appropriate changes in the inputs they can control will give them the chance to achieve the output they desire.
Unfortunately, unlike the situation for elite athletes where the correlation between good process and good results is strong, there is a lot of volatility in the outcomes that emerge from the processes of fund managers. Poor process can sometimes lead to outstanding short term results, as measured by returns, while sound processes may produce less exciting returns. But a good process can be expected to produce more consistent risk adjusted returns over extended periods (i.e. greater than ten years).
The focus should be on the investment philosophy and process
So we don’t pay too much attention to the absolute short term returns of clients’ portfolios and encourage them to adopt a similar mindset. Rather, we focus on the following:
- Has any new research or evidence emerged which would cause us to modify our investment philosophy i.e. is there a way to improve our existing process;
- Are both we and the fund managers that we recommend to clients faithfully implementing our investment philosophy; and
- Are the investment returns generated by those fund managers within our range of expectations.
The key elements of our longstanding, research based, investment philosophy can be summarised as follows:
- Markets work – rather than trying to outguess the market (i.e. investment markets), let it work for you. Forecasting is futile;
- Risk and return are related – Only take risks that research has shown to have been reliably rewarded in the past and can expect to be rewarded in the future;
- Diversification is key – Invest in broad based asset portfolios of every asset class where risk is rewarded over the long term in a strong and reliable manner; and
- Structure explains performance – Asset allocation is the key determinant of the variation in investment portfolio returns – the rest is “noise”.
We choose fund managers that enable us to implement this philosophy in a cost effective manner. We overlay the fund manager choice with careful cash flow management and tax aware strategies to increase the chances that clients’ financial goals will be reached with as little risk as possible.
Regardless of the validity of the investment philosophy, returns will always be unpredictable. A focus on the things you can control or influence – costs, risk and taxes – ensures that unnecessary and predictable leakages to wealth are minimised.
As long as our philosophy continues to be accepted and is being faithfully implemented, a focus on quarterly portfolio returns is, at best, a distraction. The returns provide no decision making value. They will always effectively be the weighted average returns of the asset classes that make up the portfolio. When the growth asset classes perform well, so will the portfolio. When they perform poorly, so will the portfolio.
Are you progressing toward your financial goals?
Ultimately, actual portfolio investment returns will be a key determinant of whether you are able to meet your long term financial goals. But an expectation that investment decisions will be enhanced by a knowledge of short term portfolio returns, without an understanding and acceptance of the process that delivers those returns, is likely to lead to poor long term investment outcomes.
Personally, I don’t pay much attention to the quarterly performance of my investment portfolio. My primary concerns are that:
- I remain comfortable with the philosophy and implementation of the process that is generating the portfolio’s returns; and
- I continue to make progress toward my financial goals.
We would suggest that most investors would be well served adopting a similar attitude rather than hoping to glean insights by focusing on short term portfolio returns.