We Have a Problem

By Brad Thomason, CPA
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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.