Eventually It's All Relative (Returns)
Number go up is not sufficient.
Agency investment management (managing money for others who are themselves the principal) is about balancing client expectations, risk tolerance, constraints, and goals. For better or (often) worse clients tend to boil this down to a focus on returns. And it is investment managers themselves who deserve quite a bit of blame for this as it is the easy, obvious, and in many cases best single metric to answer the question "How am I doing?".
Setting aside the problems with a singular focus on return performance alone, there is an underlying problem inside of this return-centric mindset. In the long run what really matters is relative returns. Yes, this is yet another “compared-to-what?” post.
Absolute returns will determine if you get there—to your goal(s). But those should be set with a realistic expectation of what you can achieve relative to the risks you are willing to take and what various market exposures (investments) can reasonably provide.
Imagine your investment manager returns 10% annually for 10 years when your goal at the outset was to achieve at least 8% given some parameters of risk. Now imagine the manager only returned -3% annually for 10 years (a substantial loss in absolute terms) with the same 8% target.1
Do we know enough to say we are satisfied in the first scenario and unsatisfied in the second? How would we know?
An investor might feel satisfied with a positive return and especially with a highly positive return including relative to the original target as in the first scenario, but that can be a dangerous illusion. For instance you might be losing to inflation, but that is just one component of the true cost—opportunity cost, the only true economic definition of cost (forget what the accountants may have told you).
What is most important is to understand how you are doing compared to how you could be doing—returns achieved in the real world with real risk taken.
If your investment manager kept you invested as your goals and tolerances would otherwise dictate while returning -3% per year for a decade (a cumulative return of about -26%), he did you well if the appropriate benchmark (same risk in the general market, which is how you would otherwise have been invested) was down -3.4% for that same period (a cumulative return of about -29%).
“Yay! I lost less,” is never going to roll off the tongue, but it can be nonetheless true.
If your manager returned 10% per year for a decade while the similar-risk market performance was actually 11%, you should have more concern than you probably are inclined to express. Despite beating your 8% hurdle, he is actually losing value for you if that benchmark return is accurate.2 Over the entire 10 years you gained only 159% compared to the potential gain of 184%. For a $100,000 portfolio that is about a $25,000 difference—not to mention that extra $25,000 would be there for future growth if still invested.
My speed in covering a given distance is governed by the prevailing conditions including my own capabilities. I can run 100 yards A LOT faster than I can swim it. I can run 100 yards faster in good health than bad. If we don’t understand the relative conditions, we don’t really have a basis for evaluating performance. The absolute number (speed in these examples) is meaningless.
There is another aspect to this. The law of diminishing returns eventually always kicks in, which means absolute returns are as unhelpful as past performance can be (that’s why it “doesn’t imply future performance”). Trees don’t grow to the sky, wealthy economies don’t grow as fast as emergent ones, large companies change less quickly than small ones, a sprinter’s last steps do not increase her speed as much as her first ones off the block, etc. To hold performance accountable we have to know what the proper comparison is.
Remember: The market doesn't care about your required return. The market doesn't care what you want to achieve. You should care about your required return, what the market can achieve, and how those two can be reconciled.
The S&P 500 has been both much better and slightly worse than these two scenarios in certain 10-year periods over the past 40 years.
The fact that benchmarks tend to reflect no fees, an unrealistic assumption, is the only potential saving grace here. However, a 1% fee for investment itself (not all the other potential services a manager brings, but just the pure market exposure) is a quite high rate. In this case we are talking about expense ratios of 1%—a very high rate for public markets today—thank you, again, John Bogle.