By Brad Thomason, CPA
We have a problem. A measurement problem, to be precise.
If you are a money manager and you are trying to convince the client/potential client population that it is sensible for them to pay your fees, the most straight-forward way is to demonstrate that your approach beats the market.
There’s an extra layer of complexity that we could add to this discussion, in which we talk about doing so at levels of risk that are less than market risk – followed by a lot of arcane and swirly exposition about how exactly one gauges and expresses such risk. But even if we have that, the thing most people are going to look at is whether or not the manager beat the market return. A particularly thoughtful client might listen to an explanation of how a sub-market performance was expectable and acceptable due to the dramatically decreased risk. Might even give it buy-in and feel like they are a member of the enlightened, among a mass of the dim. Might even be right about that, as a matter of fact.
But let’s face it: if you’re a manager, the easiest sales pitch is one in which you can claim (legitimately, of course) that your process did better than a market/index investor would have done.
As such, the investor community gets a lot of sales messaging from the manager community about returns. Mornignstar, in fact, exists for little reason other than to facilitate such comparisons.
None of this is hard to see. None of this is hard to understand.
Also, none of this actually addresses this problem I alluded to before.
With all the talk of returns and market comparisons, it’s easy to lose sight of the fact that as an investor, your goal is not to beat the market. May be your manager’s. But it isn’t yours. Or at least, I would argue, it shouldn’t be.
Asked differently: What, exactly, should you, as an investor and not a manager, be more concerned with measuring as the basis of investment success?
Here’s a quick, one-question pop quiz to prove my point:
If Sally needs to earn 7% this year in the stock portion of her retirement savings in order to keep her plan on track, and the market falls 35%, will Sally be happy about the fact that, due to her manager’s good ministrations, she is only down 31%?
I’m bettin’ the answer is NO.
What do you think? Does the manager’s market-beating performance end up being what matters most in that little tale?
An old poker player was once asked how he managed to maintain a good streak against the latest crop of young, aggressive gunslingers. He said it was simple. You just had to remember that poker wasn’t about winning hands; it was about winning money. While the youngsters were smashing each other up trying to see who could “take down more pots,” the old guy just sat back until a) he got good cards, and b) the other guys had already thrown in a bunch of money ahead of him. Then he stepped in and cleaned them out. Sometimes one or two pots in an entire night were enough to send him home with big wins. He played a different game than the other guys, simply by remembering what was important and what wasn’t.
On the day you retire, which do you think will matter more to you: whether you got the returns you needed during the growth years, or the number of times during those years that you beat the market?
Measurements and goals which focus on the wrong thing are a clear path to problems. Luckily, in this case, it’s easy to fix. Let your manager worry about beating the market and all the promotional value that goes with it. You just make sure you’re doing what you need to do to get the returns your plan says it needs each year, even if those returns are less than you could have gotten doing something else. If you needed 7% in a year and you got 7%, that’s a winning year. Everything else that went on outside of your portfolio, including the market return, is in distant second in terms of its importance.
By Brad Thomason, CPA
Clearly, it was one of the better ideas that any one had ever had. Twas the week before Christmas and I was zipping through the local Walmart to get a few ingredients for dinner, and check something in the sporting goods section for a last minute gift. For reasons I can’t really explain, I veered down one of the toy aisles, and saw a box containing five jigsaw puzzles. Each was a movie poster-style picture, depicting one of the Pixar movies. Though an infrequent impulse buyer, I scooped it up and took it home, nonetheless.
Then I opened all five puzzles at the same time…and dumped all the pieces into a single container. All 2,350 of them. Well, 2,349 of them, as we would later learn. But you get the point.
This action drew various responses from members of my family, which ran the range from, “Oh my gosh, Dad,” to “What have you done?!”
However, for the next two-and-a-half days this stroke of unappreciated genius lead to the proverbial “hours of family fun.” The kids (who aren’t really kids anymore…) and I sat at the dining room table for hours, listening to music, singing at varying degrees of volume and quality, talking smack to each other, and grinding through the substantial task of divide-and-conquer that I had manufactured. Some of us stayed up late; others of us fussed at the first group the following morning for all the noise. It really was a lot of fun. And in the end, we did in fact sort the mess and solve all five puzzles. Ten minutes before dinner on Christmas Eve. So we took a quick pic, destroyed the evidence, and returned the room to its intended use, as if the whole puzzle-gate business had never occurred. All-in-all, a pretty cool holiday memory.
Spending all of that time working those puzzles really drew my attention to one of the basic truths of the universe, not exactly news but one that’s still worth mentioning on an endless loop. Sometimes it takes a while to really see what’s right there in front of your face.
If you think about it, what better example of this principle could there be than a jigsaw puzzle? Once you flip the pieces right-side up, you are literally looking at everything you need to know to put the puzzle together, in a single view. Yet it takes hours of going back over the same terrain to actually see what you need to see to do it. I couldn’t tell you the number of times one of us announced that it was a certainty that a particular piece was simply not there, only to find it some minutes/hours/days later. As I mentioned above, there was only one piece actually missing by the end. But there were many more assumed-to-be missing pieces throughout the course of the project. “Hidden in plain sight” was much more than a turn of phrase for all of us by the time things wrapped up.
To work a puzzle you have to stare. You have to look at the same thing more than once. You have to accept that there will be realizations which come later, and you have no earthly idea why they came that time and not before. To do so takes attention, focus, and above all, time. Like erosion, it’s a business model rooted in sustained pressure over long duration.
If you think about it, as you have gotten older, isn’t it the case that knowledge has become less about going wider, and more about going deeper? I’m not suggesting a person ever runs out of new things to learn, especially when it comes to hobbies, and travel and things like that. But the big stuff, the core matters that affect everyone moving through the adult world? You had all that pretty well in hand decades ago, didn’t you? Or, at least you had the basic version, the 75% to 80% you needed to know to not completely make a mess of your life.
Since that time though, for me anyway, the important growth in knowledge has come from going deeper into those things. From trudging on down the path, full in the grips of diminishing return, to try to go from 80% to 90% and then to 95%. From looking at what I’ve already looked at before, even thinking things I’ve already thought before, in the hopes that the continued engagement will spawn some new realization. Miraculously, such efforts almost always deliver the goods.
As complex topics go, retirement is one of the deeper wells that I have found. It is deceptively complex, likely because of the vast number of moving parts which may come into play. To really understand the major principles requires lots of time and contemplation. And to study every little fold and nuance? I don’t know, but I’ll tell you later if I ever get there.
Part of doing well at retirement, I think, is making sure that you have realistic expectations about how long it’s going to take just to understand what it is that you need to be doing. Then, allocate the time and put in the hours.
No one expects to solve a 1,000 piece jigsaw puzzle in half an hour. If retirement was an actual jigsaw puzzle I’m not sure how many pieces it would have. But a lot more than 1,000. Or even 10,000, I imagine. Strictly speaking I don’t really know because I’ve never tried to tackle one with that many pieces. If I did though, I wouldn’t expect it to go fast, and I would (hopefully) not let myself get discouraged that a big block of time would be required to achieve the goal.
Which, I think, is a big part of the prescription for how to approach comprehensive retirement planning. You just gotta take time to stare. Then, stare.
Well, the new Thor movie is out, in case you missed it. In celebration of Marvel’s five-thousandth contribution (or is it more?) to the cinematic world, I thought we might take just a minute to think about what makes for a good super hero.
To be certain, there is a whole range of standard cool powers out there, nowadays. Since the earliest origins back in the age of mythology, the typical menu offerings are now well-established. Sort of like the Tex-Mex joints you can find everywhere, from big cities to small towns. Just as there’s no rarity to steak quesadillas or enchiladas with red sauce, flight, teleportation and blasts of energy are there to be found most anyplace you look.
But back at the basic level, it strikes me that the three characteristics which seem to underlie all the rest are speed, strength and an ability to withstand damage. If you have just those three, even if you can’t shape shift or move objects with you mind, you still end up being pretty formidable.
Take The Flash, for instance. Obviously he’s got the speed. That’s his thing, after all. But he also has strength, by virtue of that formula from your old science book that you nearly forgot: Force = Mass x Acceleration. If you have plenty of acceleration – as does The Flash – then you can also get up to plenty of force. And since his metabolism is sped up too, he heals faster. So damage can’t accumulate in the same way it would without that ability.
Fast, strong and hard to hurt.
Superman? Yes, yes, there’s flight and heat vision and super-cool breath and the overall relentless do-gooder vibe. But underneath all of that more obvious, snazzy stuff? Same three.
Well, what does that tell us about ideals to pursue in arranging our capital?
One of the under-discussed, important topics in investment management is capital efficiency, or the speed with which one moves from this investment to that one. If you get ready to sell a rental house after the tenant moves out, even if they leave a substantial mess and a list of repairs, you can probably turn the thing in about three weeks with the right crew and the ability to focus. So if it ends up taking three or four months to get it physically squared away and sold, that’s an example of a not-efficient transition. Your capital sat idle, not earning anything, for a couple of months when it didn’t need to.
When one investment has run its course and it’s time to move to the next one, the smaller the delay, the greater your long-term, overall rate of return at the portfolio level. When it’s time to move, there is benefit in moving instead of putting it off.
On the strength front, any time folks start talking about earning high returns, the conversation routinely gets swept off to the side and morphs into a set of admonitions about watching out for risk. Don’t let all that star dust you’re hoping for blind you to the possibility of losses. Frankly, I’m as bad about doing that as anyone out there.
Yet, high returns, strong financial performance, carry a lot of importance. Big results are great when you can get them, no doubt about it. After all, in a sense, isn’t earning a bunch of extra money one of the best ways you can think of to decrease the risk of eventual financial failure or collapse?
Investments which powerfully deliver what they are supposed to –and maybe a bit more – year after year are the foundation of a lot of the wealth you will eventually come to have. So picking things which have good prospects, even knowing that some of them won’t pan out as hoped-for, is still a better strategy than thoughtlessly loading up on every remote possibility that comes your way, on the long-shot chance that maybe something will turn out well. If you are not intentionally pursuing returns with your investment choices, you’re sort of missing the point of the whole exercise; even if returns aren’t the only important thing to think about.
Which is a nice transition into our final topic. Diversification is universally understood to be the thing you do to be able to absorb some hits without getting knocked out. Though there are a lot fewer people out there who really get the mechanics of how to put the principle into action. Two simple keys will get you pretty far down the road, though.
First, is the basic notion that you don’t want a particular kind of negative event to lead to a decrease in all of your holdings simultaneously. This is relatively easy to address: if all of your holdings are in one kind of asset, AND it’s a type of asset that is susceptible to big swings (stocks, real estate, closely-held business, etc), cut it out. Move some of your money into something else.
The second point is a bit more nuanced. Although you would like to avoid down-turns altogether, you may not be able to. Especially if you are still in the part of the cycle where you are building wealth (versus late in life, and living off of the income and wind-down of capital which was made decades before), it’s more likely than not that some of them will come your way from time to time. So if there is a certain inevitability to such events, the question is how best to cope with them. The answer: as you approach the transition to the retirement income years, don’t end up in a position where you will have to liquidate a depressed asset to meet current cash/income needs.
Take the stock market for example. There have been lots of times throughout the years that it suffered a significant drop in value. But in all past instances, not counting the one we are currently living through, it has eventually recovered to previous levels. It just took it awhile to do so.
During the recovery period, people still had bills to pay. Those who had their capital arranged so that they could leave the stocks alone to recover, and draw their cash for income from other holdings, eventually saw their stocks return to former values.
But those who did not have other pools of money available and had to sell their depressed stocks did not participate in the recovery. They left the market before it rose again, and what was a temporary aggravation for our first investor, was a permanent loss for them. Same market decline, same market recovery, vastly different levels of damage.
Our first investor, in other words, was harder to hurt because of an understanding that a major aspect of diversification is the existence of multiple options within the broader portfolio for how to create liquidity. Steps in the past made it so that in the present he wasn’t stuck doing something he obviously didn’t want to do (i.e. realize the discount).
So there you have it. Want to take a page from the super hero playbook? Focus first on the big three: fast, strong and hard to hurt. Then, once you’ve got that squared away, if you want to start learning how to talk to fish, or change the weather, fire away.
Older blogs (2015-2017)