How do you judge performance?

Good returns lie in the eyes of the beholder. Put another way, perception is reality and your perception of what a good return means becomes the reality. Why is it that some people are happy with an 8% return while others are grossly disappointed with a 9% return? Your expectations change the way you judge performance.

Annualized performance vs. calendar year performance

When markets are down, returns can be downright depressing. The problem is something called end date bias. Here is an example:

You have Investment A; this fund for four years makes no money and loses no money. Over the four years, this fund has a 0% rate of return. In the fifth year, this fund makes an astounding 100% return. Would you buy this fund? You might if you see the Annualized performance, which is the type of information you will find in the newspapers.

Calendar 2006 2007 2008 2009 2010
Performance 0% 0% 0% 0% 100%
Annual 1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
Performance 100% 41.40% 26% 18.90% 14.90%

On the other hand, you might have investment B. This fund also makes no money for the first four years. In the fifth year, this fund hits a bear market and loses 50% in one year. Again, there is a dramatic difference between Calendar performance and Annualised performance.

Calendar 2006 2007 2008 2009 2010
0% 0% 0% 0% -50%
Annual 1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
-50.0% -29.3% -20.6% -15.9% -13.0%

Finally, imagine an investment that demonstrates amazing consistency producing returns of 10% for four years straight. In the fifth year, this fund also hits the bear market and loses 50%. Despite making 10% for four years straight, the final year has a dramatic effect on the types of information you will see in the newspapers.

Calendar 2006 2007 2008 2009 2010
10% 10% 10% 10% -50%
Annual 1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
-50.0% -25.8% -15.4% -9.7% -6.1%

Expectation of returns

The biggest danger investors’ face today is their expectation of returns. We have just gone through one of the strongest bull markets in history and earning double-digit returns was the norm. Recently, we have seen more market volatility as a result of inflation, interest rates and the economy. Tomorrow, we may not see the ‘perfect’ market conditions we saw in the 90’s. Looking ahead, I offer some tips for investors when it comes to judging performance:

  1. Past performance is no indication of future performance. Returns you have seen in the past are not necessarily indicative of long term future returns. Short-term performance can greatly skew your perception of reality.
  2. Regression to the Mean. We may start to see returns closer to the long-term averages (1950 to 1999) for Canadian Investors:
    • Cash returned 6.4%,
    • Bonds returned 7.5%,
    • GICs returned 7.8%,
    • Canadian stocks returned 10.9%,
    • US stocks returned 14.0% (source: Andex Charts)
  3. Use objective Benchmarks. The key to properly analysing performance is to establish certain benchmarks or standards. Without standards, we have no targets and no means of true measurement. There are two great benchmarks that should be used to judge performance:
    1. ZERO – This benchmark measures a fund’s ability to make money. I caution you to know that any solid investment must be given a reasonable amount of time to perform. For me, that means a minimum of three years. Investors should have enough patience to wait out at least a 3 to 5 year period.
    2. AVERAGE – This measure speaks for itself. With almost 3000 funds to choose from it is reasonable to look for funds that spend more time being above average than below average. With this standard, every mutual fund is competing against each other to get your hard-earned dollars. This represents a relative benchmark because it shows how a fund has performed relative to all the other funds.
    3. GICs – This benchmark is used to measure the “risk-free” return. The ultra-conservative investor requires that you must beat the risk free return to justify more risk. Common sense says that this moving target is easier to beat when interest rates are low like most of the 1990’s but very difficult to beat when rates are higher like the 1970’s. Common sense must apply.
    4. INDEX – Much publicity has centered on a funds ability to beat the index. The key to comparing against an index is to use the appropriate index. For example the TSE 300 is used to compare against Canadian Equity Funds. It would not be appropriate to use a bond index or the S&P500. Many investors feel that the fees they are paying for owning a mutual fund are only justified if they can outperform an index. Therefore it may be important to determine if a fund has been able to beat the appropriate index. Judging performance is no easy task – Be sure to understand the benchmarks.
  4. Be aware of the problem of end date bias. When looking at performance, do not just look at the 1,3, and 5-year performance numbers. Even a 5-year number can lead you into a false sense of perception. When looking at performance, be sure to also look at the calendar year performance. The best scenario is to look for trailing returns, (which is much harder information to find and understand).

In the end, judging performance is no easy task – Be sure to understand the benchmarks.

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