It’s natural to assume that superior investment performance results from superior manager skill, and below average investment performance reflects subpar manager skill. Using only investment performance to measure a money manager’s ability has some advantages: it’s easy, it’s widely accepted, and it feels good.
The problem is, great managers often go through slumps and periods of disappointing performance, while below-average managers often have extended periods of superior performance. Even Warren Buffet, the “Oracle of Omaha,” and his company has lagged recently. Likewise, even the most amateur investment managers can get lucky every now and then. As the saying goes, “even a broken clock is right twice a day.”
Because there can be such inconsistency and volatility in the markets, it goes without saying that investment performance and investment manager skill are often not correlated. Here are five critical drawbacks to using investment performance as the only metric when assessing a financial manager’s skill and expertise.
1. Investment Performance Is Always Backward Looking
Investment performance measures what has been and is a relatively poor predictor of what will be. Many factors impact investment performance, including the relative performance of different sectors of the market, the movement of interest rates and a healthy dose of randomness.
When we assume past performance is an indicator of future performance, we are betting that current market trends will continue. The challenge is that the markets are dynamic and constantly changing. It is amazing how often today’s winners end up being tomorrow’s losers.
2. Investment Performance Is Time-Sensitive
The timeframe used to evaluate a manager can dramatically impact the results. A manager might be slightly lagging their benchmark over a three-year period, dramatically outperforming over a five-year period, and trailing badly over a 10-year period. Depending on the timeframe you focus on, you might think the manager is great or terrible.
In the investment world, it’s amazing how often fortunes change and stellar managers go through years of underperformance. A manager’s performance over the last three or five years says very little about their expected performance over the next five.
3. Investment Performance Is a Relatively Blunt Measuring Stick
Evaluating a financial manager based solely on investment performance may only show you a fraction of the whole picture. To use a sports reference, making evaluations based only on investment performance is like evaluating an entire game when you’ve only seen the final score. Sure, it tells you who won and lost. But maybe the game wasn’t as close as the final score indicates. Maybe all the scoring happened right away and then it was boring until the end. Maybe one team mounted a miraculous comeback, or maybe that comeback came up just short.
In much the same way, investment performance doesn’t account for differences in portfolio construction, and it often doesn’t identify what are the main drivers of the portfolio’s return. It often is not adjusted for the differing risk profile of the manager compared to the benchmark. It doesn’t account for certain benefits such as asset allocation and tax-loss harvesting to reduce taxes.
4. Investment Performance Might Be the Wrong Focus
When you only look at investment performance to measure your portfolio, it’s possible you risk shifting your money manager’s focus from doing what is best for you to doing what is necessary to beat the benchmark. Your goal shouldn’t be to get the highest possible return; it should be to get the rate of return you need to meet your goals. If your investments are lagging and you’re constantly measuring them against the benchmark, your investment manager may be motivated to increase the portfolio’s risk profile to catch up—thus deviating from your carefully constructed financial plan and exposing you to greater risk.
5. Investment Markets Can be Random
Any financial advisor will tell you it’s a fool’s errand to try to time the markets. That’s because there will always be unexpected twists and turns that can suddenly tip the markets in either direction. This is true over the short term, and it’s also true over multiyear periods.
A financial manager’s investment performance may be more about the market’s random movements than their own skills. An overreliance on investment performance as a measuring stick may lead you to draw erroneous conclusions about a manager and their team’s skill and insights, either positively or negatively, without taking things like overall market performance, current events, etc. into account.
Does this mean you shouldn't look at investment performance? Absolutely not. Investment performance is one of six key metrics for the prudent investor. It just means that it shouldn’t be the only thing you consider when making investments or evaluating your investment manager.
Instead, it’s important that you work with your financial advisor to develop a carefully constructed plan—one that’s able to survive the inevitable ups and downs of the markets—that can help you reach your specific financial goals.
CFP® David joined Wealth Enhancement Group through the partnership with JOYN Advisors, where he acted as CEO and Co-Founder. He is the creator of the Behavioral Wealth Management™ model. A model that focuses on aligning wealth management with the integration of human emotions while taking into consideration an individual’s talents, wisdom, network and relationships. David has been featured in a number of prominent outlets including The New York Times, The Wall Street Journal and The...Read More