As we come to the end of the year, conventional wisdom says that investors should review their portfolio’s annual performance (returns). When the number is positive, most investors conclude it was a “good year”, close the books, and go on to celebrate the new year. But when the number is negative, investors start to feel uneasy. If the portfolio return was negative in a year where the market (S&P 500, Dow, Nasdaq) was up by close to double digits (like this year), the situation feels worse. Further, if the previous year was also negative, then another negative year would mark the second year in a row of losses. You would then likely feel a shiver down your spine, followed by a slow sinking sensation in the pit of your stomach, and you can’t help think that something went terribly wrong …. again.
You start reviewing your individual holdings, hoping to find a mistake or that only one or two stocks have been slightly “under-performing”…. only to find in horror, that most of your investments are in the red, and by double digit percentages. How could this happen? You thought you’ve learned your lessons from the financial crisis and dot com crash. You have been doing your due diligence, crunching the numbers, making sure your valuations were ultra conservative, and you only invested in great businesses at low prices. You even have a number of solid dividend paying stocks. Where did it all go wrong?
Sound familiar? Well, you are not alone. This is likely the case with most investors. Personally, my own annual performance numbers have looked terrible over the years using the traditional performance and evaluation metrics! And in many years, my numbers happen to be negative on December 31st, with various holdings down as much as -30% in certain years. But each year I’m quite satisfied with where my investments stand and with my investment decisions & actions. The “performance” or “results” are often inline with my expectations. Why? Because I don’t give any importance to year-end performance numbers.
In this post, I will discuss why conventional portfolio and investment evaluation metrics are not meaningful or relevant, and why investors should not rely or pay too much attention to them.
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Not Relevant & Not Accurate
Conventional performance metrics look at investments in a portfolio as a whole, which is why at first glance, it can make your numbers look better or worse than the major stock indices and other investment options such as index funds, mutual funds, etc.
Conventional methods for evaluating the performance of a portfolio and investments are based on the calendar and the market price, but do not show us information that we need to know. They are not relevant, and not accurate reflections of performance or what is actually happening. This is because they do not take into account specific dates or events related to individual investments, opportunities, time horizons, expectations, the true intrinsic value of an investment, the changes made in the portfolio or their relation to the overall strategy, or the role of each investment. Therefore, such metrics are not very meaningful and ultimately not very useful for investors. It’s usefulness is extremely limited and full of shortcomings.
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Conventional Performance Metrics Are Calendar Based
Annual calendar-based portfolio results are not meaningful for investors, as there is no meaningful correlation to the year-end calendar date. It also does not provide an accurate reflection of performance as it is not aligned with investments or the investor’s time horizon.
December 31st has no relevant meaning for investments:
December 31st normally doesn’t mean anything for an investment, as nothing material happens on the 365th day of the year. The only likely event may be a distribution or interest payment made to an investor. But this is not going to apply to most investors.
Example: Calloway REIT [CWT.UN] will be completing a reorganization on December 31st 2014, in order to eliminate it’s subsidiary trust, whereby Calloway unit holders will receive additional units of the trust. How many of you own CWT.UN or have investments with something material taking place on the same day?
December 31st normally marks the end of the fiscal year for a business, but from an investment perspective it is non-material. Financial reports and results are usually filed with the SEC a month and a half after the reporting period. Some companies also set their fiscal year-end in a different month.
Example: Disney’s [DIS] fiscal year-end is at the end of September, with the reports filed in November.
Each investment has their own specific schedule and dates (based on dividend dates, business milestones, purchase/sell dates, etc). Those specific dates are the important ones.
Investment decisions & actions are based on opportunity, value, and strategy. They are not based on a single annual calendar date.
The reason behind investing should be to create long term value and align strategies, decisions, and actions with available opportunities. These opportunities largely become available on a random basis, and are not tied to any particular calendar date. There also isn’t a sudden abundance of opportunities being made available at the end of the year. Similarly, there isn’t a higher amount profit taking opportunities in December, as investments do not suddenly peak in market value.
The strategies and the decisions & actions that follow investment opportunities, therefore do not correlate or coincide with a specific calendar date each year (and certainly not December 31st).
Annual performance evaluation does not take into account the time horizon of the investments or the investor.
Evaluating an investment portfolio at the end of each year, does not align with the time horizons of individual investments or of the investor. The time horizon of an investment or it’s underlying business is a very important aspect of investing. It is the expected time frame of when an individual investment is expected to behave in a certain manner, or ultimately become profitable. However, it is often overlooked or given little consideration, because it is a gray area. It’s not a one size fits all attribute, and requires specific knowledge of each investment and of the investor. It is difficult to define in a precise manner, and is different for every investment and therefore different for each investor portfolio.
Example: An investor may capitalize on a flash crash price decline of a specific stock, where the expectation may be a partial price recovery within a very short time period (less than one year). Evaluation of the recently acquired investment may even occur before the end of the year. In contrast, an investment in a junior mining company that is still in the early exploration stages and years away from mine permitting, would likely have a much longer time expectation (5 yrs for example). If an investor purchased such an investment in June, it wouldn’t make sense to evaluate it’s potential return (if hypothetically sold) only 6 months later.
Similarly, an investor’s overall time horizon is equally important, but is not reflected through the conventional calendar based assessment.
Example: In the first example above, the investor may have a completely different expectation of when the investment should produce a profit. The investor may capitalize on the same flash crash opportunity, but yet have the intention to keep the investment as a very long term holding. In the second example, the investor may have a 10 yr expectation for the mining stock and may evaluate it only after ore production has reached a certain threshold.
An investor’s personal time horizon, combined with their level of experience and knowledge is a significant factor affecting performance. If an investor is just starting out, an evaluation of their portfolio or investments in the first or even second year may not make sense. Warren Buffett has continually recommended investors use a minimum five year time horizon for investing.
A shorter term evaluation of performance would not filter out randomness or chance (positive and negative), and give an inaccurate reflection of the investor’s skill, knowledge, and decisions.
Example: A good example, is evaluating the performance of an investor who has only been investing after 2009 (during a period of broad market increases), versus the performance of an investor who has been investing since prior to 2000 (experiencing both severe declines and significant increases). In the later situation, the effects of chance, luck, and randomness, are largely shaken out. The longer the time horizon, the larger the role and impact that skill and knowledge play (or lack of it).
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Conventional Performance Metrics Are Based On Market Price
Assessing performance based on market price (mark to market) does not provide an accurate reflection of true value or realized gains or losses, and is often irrelevant for our needs as it does not take into account investment strategies or the role of an investment.
Market prices do not accurately reflect the true value of the underlying investments held.
Evaluating performance based on the current market price at an arbitrary time is not meaningful, as it does not accurately reflect the underlying asset’s true value. It is particularly irrelevant if you have no intention to sell the investment, and will not be forced to sell during unfavorable prices. It makes even less sense, when such an evaluation is extended over the entire portfolio, when there is no intention to sell all investments in the portfolio and there is no real likelihood that you would be forced to do so.
The current market price of an investment is influenced by various factors at any given moment, most of which are not always relevant or related to the actual investment. Factors such as overall investor sentiment or the current direction of the broader market, have nothing to do with the underlying asset. Yet, these factors can heavily influence an asset’s short term market price.
Example: In mid-September of this year, the S&P500 index declined from 2010 points to 1862 points by mid-October, and then returned to the 2012 point level by early November. Did the true values of all the companies in the S&P decline -7.3%, only to return to its value prior to the decline less than a month later? No. The overall market sentiment was reflected in the decline, as investors wanted to pay less for stocks as a whole, and then changed their mind and were willing to pay more again.
The aggregate market prices of current investments held do not reflect realized investment gains and losses, and can hide them. Real performance results are masked by market prices.
The market prices of investments current being held do not reflect any realized gains or losses from investments that have been sold (dispositions) or dividends/distributions received.
Whenever investments are sold, the gain or loss incurred is real (realized). It is money that will go into your account, or money that has been lost forever. This represents the true performance of the individual investment sold. It is also the result of the strategy and decisions that were related to it. However, the collective market prices of all investments held in the portfolio, can hide any individual positive gains or negative losses that have been realized.
Example: If the entire portfolio had a collective increase in market price that is larger than that of any losses incurred, then the overall “performance” will look positive. The aggregate will hide the negative results of the real individual losses. Similarly, individual realized profits can be overshadowed.
Dividends and distributions (income) from investments can also be considered real results, as it is money that gets deposited in your account. They too, can be hidden by the aggregate market prices of the entire portfolio.
However, this problem of the aggregate masking real performance is a broader issue that goes beyond just market prices. A similar effect can take place just among realized investment gains and losses alone. Large profits from one investment can hide smaller losses (and vice-versa), distorting the actual performance results.
The market price of new acquisitions (or the lack of them) can affect the aggregate “performance”.
Purchases during the year can weigh down performance numbers, especially during years where a lot of new investments have been made.
Value investors often buy when an investment has declined in market price and is trading at a discount to the true value. Because the market price has declined, we often see the price continue to decline for a period of time after the investment has been acquired, as it is impossible for an investor to predict the absolute bottom. If the market price does not change above the acquisition price, the new purchases will show negative performance results. This effect is compounded when there are many such new investments that have not yet risen above the investor’s book value (cost) or have declined further. Conversely, a lack of new investments in a particular year would not affect a portfolio’s annual performance in the same manner.
Example: If your portfolio only had 30 shares of Berkshire Hathaway [BRK.B] stock, the annual performance of your portfolio by December would be roughly 28.5% (the price increase of BRK.B shares alone) and worth $4530.
Now, suppose you injected capital into your portfolio and initiated a $3000 long term stake in Taylor Morrison Home Corporation [TMHC] in mid-May at a price of approximately $20 per share (150 shares). Your portfolio’s year end performance would now yield only a 10.8% increase, due to the impact of TMHC shares declining -10% to approximately $18 by December (worth $2700), which negates the market price increase of the BRK.B shares.
However, lets consider if you injected additional capital and also initiated a $3200 long term stake in McEwen Mining Inc [MUX] at the end of September at a price of $2.00 per share (1600 shares). By December, the market price of MUX declined -50% to approximately $1.00 a share (worth $1600). The decline in market prices of both the TMHC and MUX shares would completely overshadow Berkshire’s 28.5% increase, resulting a decline of -9.2% for the portfolio! Note that if the prices of both TMHC and MUX did not change since their purchase, the portfolio’s overall return would still be affected, but the result would be 18.7%.
When a portfolio holds much larger stakes or many more mature investments (i.e. investments that have been initially purchased years ago) that have had time to appreciate in value or distribute a significant amount of dividends, then (in general) the portfolio’s performance is much less likely to be negatively affected by the low market prices of newer acquisitions.
Example: In the previous example, if 100 shares of Berkshire were held instead of 30, the portfolio’s return would be 8.1%. The market value of the Berkshire shares ($15,100) would mask the market price declines (below book value) in the newer and smaller holdings of TMHC and MUX. More mature investments may also be more positively affected by market prices that are approaching true the values of the underlying assets. In both situations, the performance results of the portfolio is distorted.
Market prices do not accurately reflect the results of the intended strategy or function/role of each investment.
Market prices are a snapshot of what the market is willing to pay for an investment at any given time, which is all that it is. It cannot adequately convey details regarding an intended strategy, nor does it give any insight into the intended role or function of an investment.
Example: This can be best illustrated with investments that are purchased solely for income (dividends/distributions), with the investor reinvesting the dividends into mores shares via a dividend re-investment program (DRIP) as a simple strategy, and has no intention of ever selling. Stocks that are enrolled in a DRIP actually benefit from a lower share price. A decline (negative change) in the market price to a level below an investor’s initial book value is actually a positive situation, as it means the distributions are being used to purchase shares at a better price than when originally purchased. It also means that reinvested distributions can be used to acquire a larger number of shares (depending on the total distribution amount and the actual price of shares). This would result is a larger compounding effect of the distributions over time. This kind of situation is particularly beneficial when the DRIP is in effect for an investment that pays distributions on a monthly basis (Canadian REITs are good examples).
For investments purchased solely for income, if the underlying business is able to continue making distributions over the long term and into the foreseeable future, then the investment can be evaluated as performing well. It would be fulfilling its intended role and benefiting from the simple reinvestment strategy in a situation of lower share prices. However, using the market price, the “performance” will appear negative overall, as the annual decline in market value may be larger than the amount of distributions received.
Market prices are not relevant for all investments or all stages of an investment.
Price changes is not a relevant metric for all investments or for every stage of an investment.
Example: One example where market price is not a relevant metric, is with bonds. It does not affect the ability to meet payment obligations, and also does not affect the distribution amounts. Bond price increases/decreases are only a reflection of investor sentiment, which may or may not be attributed to investors’ thoughts on the ability to make payments. It should not be taken as a reflection of the actual ability to meet payment obligations. Market prices for bonds may not even change much if the bond was a new issue and the investor did not purchase it at a discount (i.e. not purchased to capitalize on price appreciation due to short term price weakness).
Investments often have different stages where they can be expected to perform or behave differently. Therefore, changes in the market price does not always correspond to the investment’s specific performance at a particular stage.
For example, an investment may be initially purchased during severely depressed prices. During the initial stage the price can be expected to decline further. At some point the investment can be expected to increase in market price. However, after the increase in market price more accurately reflects the underlying value of the investment, there may be smaller price increases that follow, but a larger change with the dividend aspect.
Example: This can be illustrated with my investment in Macerich Co [MAC] and it’s different stages from 2007 – 2014. During the real estate crisis of 2008, the share price of MAC became severely depressed. I initially purchased shares after the stock plunged from the $100 level in 2007, down to the mid $30 level in the third quarter of 2008. During the earliest stage of my investment, the shares decline further and I added to my stake multiple times along the way down to the $6-$7 level. The 2008 “performance” of my portfolio was negative, largely due to my increasingly large stake in MAC which declined -79% in market price since my initial purchase. The performance was well below -40%, even though Macerich was yielding over 30% in dividends on my investment. There were also many other similarly deep discounted type investment purchases which weighed down the overall portfolio “performance”. Any realized gains and dividends were completely hidden. During the first quarter of 2009, the share price had continued to drop and hit a bottom at roughly $5.80. By the summer of 2009, Macerich had reduced their dividend but was still yielding roughly 20% in income.
The next stage of the Macerich investment began by the second half of 2009, where the share price had started to recover (78% for 2009) and appreciate into 2010 (44%). Although there was still no intention to sell the shares, it would be at this stage where the increase in market price would have been the most relevant indicator of the value investing strategy and a better reflection of the true value.
In 2011 and the years that followed, the market price appreciation had started to slow (9% in 2011, 11% in 2012, 0% in 2013) marking the next stage, which saw quarterly dividends steadily increase from $0.50 to the current level of $0.65. During this stage, price increases are no long relevant. Dividend increases and the resulting dividend yield on the initial purchases (+20%) is my primary focus, as it captures the strong growth and profitability of the company.
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Why are these conventional metrics used?
Why are these irrelevant and inaccurate conventional metrics used? There are a few main reasons:
It is clear and simple to calculate, and therefore easy to understand:
The math is straightforward, and can be explained to a client with ease. A client with little financial knowledge can verify the numbers.
The subjective aspects of the true value of underlying assets and evaluation of performance is avoided:
The intrinsic value of an investment is highly subjective and every investor will come up with a different number that is estimated in a different manner. An investor has control over the factors in which such an estimate is derived. Progress of an investment and evaluation of it’s performance is also subjective. Each investor can focus on different milestones or criteria, and prioritization of such aspects are based on the individual.
By using market prices to measure performance, subjective aspects are removed. The management firm or financial institution does not have any influence over the factors used to measure performance (indices, market prices). This makes the information less meaningful, but also less vulnerable to manipulation.
It provides standardization across the investment industry:
Provides an easy and standard method (but not useful) for investors to compare products/funds and management services. It also provides a framework for compliance to regulatory bodies. A standardized and yearly time horizon provides a means for reporting on regular annual basis.
Customization requires too much effort, is extremely difficult to implement, and also requires staff & clients to have more knowledge:
Customization is too complex and subjective to be applied across financial institutions and management firms, for every individual client in a standardized manner. It would require much more work, investment acumen, and specialized knowledge. Staff at retail banks and other financial institutions would no longer be able to sell investment products without acquiring more knowledge and experience (which also complicates the ability to move staff laterally into different roles). Similarly, it would also require clients to have a better understanding of investing and some knowledge in the area.
Clients will no longer be suitable for standardized generic financial products, complicating an institution’s product offerings and sales strategies. However, it also means that there may be less clients with enough knowledge, which would also lower overall client volume. The complexity of customization and the subjective aspects of investing, make it extremely difficult to implement across the industry. New methods of regulatory oversight would be required, which would not be easy to create and verifying compliance would be difficult. Customization and subjectiveness would make it nearly impossible to automate using standardized computer software.
Due to these reasons, metrics based on the calendar and market prices, are more suited for mutual funds, financial institutions, and money management firms. Mutual funds, institutions, and firms compete to attract clients, as well as to report to regulatory bodies. There are reasons for why these metrics are used, but it doesn’t mean you should use it, or that it provides you with any meaningful information. There are more meaningful methods which I will discuss in a follow-up post.
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It’s not an excuse to rationalize losses or poor decisions
Although conventional performance metrics are not relevant or accurate, it should not be used as an excuse to rationalize losses, or avoid taking responsibility for poor investment decisions. It also doesn’t mean that you can start making risky investment decisions or all kinds of speculative bets. However, you need to know what is really going on, and if your investment decisions and strategies are paying off or not.
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But don’t try to convince your financial advisor
Investing and business is inherently lumpy, and investors need to get used to that idea. You will be torturing yourself if you continue to expect to receive linear and regular periodic gains. Investors should expect lumpy and unevenly distributed investment profits. Your evaluation should align with the time horizons of your individual investments and with your own investment time frame. As a result, expect to evaluate performance at irregular intervals based on a variety of investment specific factors and criteria.
Conventional metrics are simply not useful for evaluating investments or giving any meaningful information to an investor. But don’t try to convince your financial advisor or people at your local retail bank. Anything that goes against convention will start an onslaught of confusion, irritation, and anger. The news, media, and financial institutions, have sensationalized the stories of the few who have followed conventional wisdom with some resulting success, and have avoided talking about the vast majority of those who have obeyed with dismal results. The majority of investors have and will continue to use these conventional metrics with extremely rooted faith. However, the world’s investing billionaires were not produced through conventional wisdom.
This discussion highlighted the limitations of basing performance metrics on the calendar and market price each year, and why they are not meaningful indicators of investment performance. The next post will focus on meaningful alternatives for assessing investment performance.
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DISCLOSURE: I own shares of BRK.B, DIS, MAC, MUX, TMHC, and do not plan on buying/selling any of the mentioned stocks within the next 3 trading days.
Thanks and Happy Investing! – The Investment Blogger © 2014