Investing basics: how do you measure investment success?

Investors often review performance against a designated benchmark, but this can result in a biased comparison - so how should you determine investment success?

Dan Kemp 20 September, 2019 | 1:12AM

Boy climbing ladder to sky

When you invest, it is important to remember that you are making a short-term sacrifice for longer-term gain. In most instances, the objective is financial prosperity, security, or the attainment of a goal, which are all typically longer-term in nature.

Primarily, investors often spend their time reviewing performance against a designated benchmark, but this can result in a biased comparison, where the wrong things are compared to each other over the wrong timeframe.

Measuring success

Imagine a scenario in which you achieved 5 per cent over 2018. Was this a success? Perhaps. How about if we added that the return was 4 per cent less than the previous year, 3 per cent above the peer-average, 2 per cent above inflation and 1 per cent lower than your desired level of return. Was this now a success? Maybe…

How about now adding the knowledge that one asset was attributable for your total return. You held other assets, but these netted off and went sideways in aggregate. You also took more risk than you would like, making you anxious at certain periods of the year. What about now? Hmm…

This example hopefully helps illustrate the complexity of appropriate benchmarking. There are many moving parts, some of which you can control – risk taken, assets held, timeframe considered – and many others you can’t.

As individuals, it is important that we can each measure our own success in a way that is appropriate to the circumstance. Ideally, this will include a robust and repeatable framework, which may or may not use benchmarking tools. The list of tools at your disposal is theoretically endless, although must be appropriate.

What tools are available?

As an industry, most investment propositions are benchmarked via one of the following:

  • Peer relative. Often done in quartiles, where portfolios are ranked against comparable alternatives on a scale of 1 to 4.
  • Index relative. Often done by basis points of “alpha”, where a portfolio is measured against a passive benchmark net of fees.
  • Absolute return. Often seeks to return a consistent positive level over time, regardless of inflation, interest rates, and other variables.
  • Real return. Seeks to deliver a level of return over inflation, growing the purchasing power of the portfolio over a defined period.

Each of these methods has advantages and disadvantages, with the most applicable likely to depend on what you are trying to achieve. For example, many asset managers benchmark against relative outcomes – from index-relative, fuelling the active versus passive debate, to peer-group comparisons – all designed to sort the winners from the losers.

This relative benchmarking is well-intentioned and can useful if considered over longer periods. However, it can sometimes misalign to the reason we invest. Perhaps most prominently, it sometimes leaves investors inclined to favour the “best” performers and yearn to be part of this echelon.

Investors similarly look down on the “worst” performers and sell in frustration. This should not be underestimated. If an investor feels that they are underperforming, they will be psychologically prone to act.

At its extreme, this impulse can lead investors down a garden path where they expect to be top-quartile performers at all stages of their journey – regardless of how that links to their desired destination.

What is the ideal benchmark?

The best benchmark is one that is forward-looking and aligned to your financial goals. In a perfect world, every investor deserves their own framework to benchmark success, with transparency, measurement, and perspective all to be embraced.

The challenge, of course, is that a forward-looking assessment is incredibly difficult to quantify, and there is no such thing as the “one-size-fits-all” approach. Benchmarking tools – such as those listed above – are powerful, but you cannot unshackle the backward-looking nature of them. What matters to an investor is whether their investment might be expected to help them achieve longer-term gains into the future.

This mismatch requires care and highlights an important point around process versus outcome. Specifically, it is entirely possible to have a strong process, or a good decision, with a bad outcome, just as it is possible to have a poor process with a strong outcome.

However, more often than not, a strong process will prevail and result in strong outcomes and vice versa. This is a key reason why we stress that people make comparisons over a longer time horizon – it allows the strength of the process, or the combination of many decisions, to unveil itself.

To bring this to life, we can suggest a checklist to reinforce the link between goals and your investments.

We split this into two distinct categories, where the idea is to first align your framework to your ambitions and then remove emotion from your appraisal process:

Checklist: aligning your framework to your ambitions

  • Is there a clearly-defined financial goal your portfolio can map to?
  • Are you appraising your investment results over a suitable time horizon?
  • If using a benchmark, is it realistic and investible?
  • Do you need to account for inflation?
  • Have you accounted for risk taken?
  • Does your portfolio stand up strongly in a forward-looking context?

Checklist: avoiding bad decisions

  • Can you avoid the recency bias i.e. focusing beyond the recent past?
  • Are you aware of your own loss aversion i.e. avoiding selling in a panic)?
  • Can you avoid the overconfidence bias?
  • All things considered, appropriate benchmarking is a powerful tool – both analytically and behaviourally. Done correctly, it can help investors stay on course and focus on the right things, but done incorrectly, it can have significant consequences.

About Author

Dan Kemp

Dan Kemp  Dan Kemp is Chief Investment Officer, Morningstar Investment Management EMEA.