Welcome to Episode 125 of Special Situation Investing.
If you don’t benchmark your returns to an objective standard then you run the risk of “painting the target after you’ve shot the arrow.” Buffett used this phrase in his partnership days to describe the human tendency to pretend the results received were the results we set out to achieve, rather than facing the fact that we might have missed our intended target.
Painting the target after shooting the arrow is an understandable human tendency because it saves us from the emotional pain of knowing we missed the mark. But emotional pain, like physical pain, can serve as a signal to our higher mental faculties that there is something wrong which needs to be corrected. As unpleasant as pain can be, we know that our lives would be much shorter without it. Pain forces us to attend to our injuries and see to our physical well-being. In the same way, emotional pain forces us to identify and attend to emotional and cognitive problems and to seek out solutions that lead us back to a healthy state.
Active investing without comparison to an objective, predetermined standard leads almost inevitably to painting the target after shooting the arrow. Without a feedback mechanism, the investor arrives at the end of the year quite happy with whatever took place over the past twelve months. If he under performed the market it’s because he bought out of favor value stocks, or because he was focused on risk control, or because he was too diversified or any number of other “explanations” that serve to comfort his ego but not to correct his behavior. Absent an external measurement tool, no after-action analysis is completed and there is no impetus to improve. In short, the investor can continue year after year implementing substandard investment practices all while happily and comfortably failing to reach his potential.
Of the investors who actively manage their own investments and who compare their results to an objective outside measure, the most common benchmark is the S&P 500. I myself use the S&P as a benchmark because it’s objective, readily available, and is the result I could otherwise have achieved with almost zero effort. It’s not a perfect measure but it is good enough and it serves the most important role which is to benchmark my performance and force me to stare hard at my own weaknesses.
Again, starring critically at your own weaknesses is difficult in the moment but is ultimately less painful than reaching the end of a multi-decade investing career only to realize that you are poorer than you would have been had you simply dollar cost averaged into an index, especially when you spent thousands of hours actively investing in order to secure your subpar returns. Again, even if the mental pain is more immediate when you compare yourself regularly to an objective standard, it is less in the end as it allows you to either improve your methods and your returns or switch to passive index investing once you accept that active investing isn’t your gift.
It must be noted here that many legendary investors suffered long bouts of under performance only to come roaring back in the latter parts of their career with eye-popping returns. Even the most consistent of the great investors have the odd year or two where they lag, sometimes significantly, an external benchmark like the S&P 500. Because this is the reality of the world we live in, each active investor must come up with their own objective criteria by which they measure themselves that allows for some occasional under performance yet still holds them accountable for their long term results results.
Personally, I enjoy the process of investing. I’ve always enjoyed learning for learning’s sake and in investing I found a craft to which I could apply my random collection of generalist studies. I also enjoy individual sports more than team sports. Outside of a little baseball when I was young, my sporting endeavors included swimming, running, cycling, surfing, martial arts and all other things individual. Not letting a team down when I failed, or having to share success when I achieved it, appealed to me and the lone wolf aspect of investing fell right in line with the rest of my personality.
Despite all of this, however, I have to avoid the temptation to use these side benefits and quirks of personality as justification for active investing in and of themselves. Intellectual stimulation and a lone wolf hobby could never be the only reason I pursued active investing especially if my results were subpar. The active investor should first and foremost deliver superior returns.
For me, the following approach allowed me to ease into full time investing while grading myself along the way. While in my teens, I devoured every book I could find on investing and selected a few individual investments on my own. Placing only a small porting of my summer job savings into my own ideas, I put the bulk of my money into standard market tracking passive investments. While pursuing a career unrelated to investing, I tracked the performance of my individual stock picks against the larger part of my indexed portfolio until enough years passed to make me confident in my own abilities. Today, only a very small fraction of my money is indexed but I still track my results against the index on a yearly and total return basis to ensure that the time spent investing is generating excess returns.
I still enjoy the process of investing, of learning, and of time spent in individual pursuits, but I don’t allow those side benefits to justify my activities. The point of actively managed investments is to out perform. The education and enjoyment derived from the activity is a nice bonus but never the reason to actively manage your money in the first place. If you can’t outperform the criteria set for yourself, it’s better for your long-term wealth to accept it and switch to passive investing so that you can maximize your income and savings in passive vehicles. In the end, more money committed to passive investing will compound to a larger sum and will save you a tremendous amount of time spent actively managing your own portfolio.
As stated before, you can conservatively asses your skills by first actively managing a small portion of your assets and comparing the results to the passively managed majority of your savings. If your actively managed investments deliver several years of under performance, then you’ve only payed a small price in lost returns and can still switch fully back to passive investments. If, on the other hand, you are able to outperform then you can increase the portion of funds that you actively manage and continue to devote more of your assets to your actively managed investments as time goes on.
Assuming that you do commit to active management, continue to check your results against whatever predetermined standard you laid out for yourself at the outset to ensure that you continue to deliver superior results. At the end of each evaluation period, compare your results to the standard you set for yourself both for the period in question and the whole of your investment history. If you fell short of your objective, determine the cause of the failure and the corrective action going forward. If you succeeded consider the reasons behind your success and the ways in which you can capitalize on your success even better in the future. Consider what could have happened under alternative scenarios to discover what risks you may have unknowingly exposed yourself to and how those risks can be mitigated in the future. Above all else, be your own harshest critic so that you can improve year in and year out. One of the benefits of investing is that you can continue improving until very late in life and your year-over-year improvements will be much greater when you compare yourself to an outside standard instead of simply coasting along.
Again, the standard by which you chose to compare your results is an individual choice and there are countless excellent criteria that can do the job. Regardless of which standard you select for yourself the key thing is that you use it to honestly assess your performance and that you implement the lessons learned from both your successes and your failures. Using this process myself, I’ve learned that I tend to be correct in the companies I invest in but that I also tend to under commit, and in so doing, don’t capture all of the upside that I otherwise could have. Because I learned this lesson through comparison to an external standard, I now force myself to commit to larger position sizes so that the returns from any one investment have a larger impact on my overall net worth. Had I neglected comparing myself to an outside standard in the past, I might have patted myself on the back for getting a 100% return in a small position but let myself off the hook for the fact that that position didn’t move the needle on my overall portfolio return.
This write up was shorter than normal and a little different from what we usually cover but it’s such an important point to consider that I thought it worth highlighting anyway. As active investors, we pour countless hours into our craft and can sometimes get lost in the process. How did this company perform? What is my next best idea? What happened in the markets today? We focus on the details and rarely zoom out to ask the big question: “Is what I’m doing adding real value over time?” In the end, that is the question that matters and the question that we should ask routinely in order to generate lessons learned and drive improvement.
Well, with that we hope you enjoyed this shorted and slightly off topic. We hope you enjoyed it and and take away something to help improve your own investing odds. We look forward to brining you another write-up in two weeks. We’ll see you then.
Benchmarking Your Returns