Measuring the Noise

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I met with a potential new client and his business advisor a few weeks ago. The client, an entrepreneur who had recently sold his business, was trying to decide how to invest his new fortune. He asked what my opinion was on how, when it comes to investing, to decide whether or not to stay with a particular course of action.

Before I could answer, the business advisor jumped in and said: “It’s simple. Each year, you add up everything you have, and see if the number is bigger or smaller than the previous year. If the number is smaller, get rid of the things that aren’t working.”

Now, this advisor had been working with my potential new client for about 20 years. I was eager to stay on his good side, so after running through a number of possible responses in my head, I came up with the most tactful way I could think of to express my honest opinion: “I think that is the worst advice I have ever heard.”

Not surprisingly, the client ended up accepting his advisor’s advice, and found someone who was more amenable to his “annual measuring stick” approach. I have no doubt this advisor had served his client in many valuable ways over the years. But even though it cost me his business, in this particular case, I remain convinced that the advisor was as far off base as he could possibly be.

The problem is that successful investing is a fundamentally different activity from running a successful business. Annual check-ups work well when it comes to assessing business effectiveness. This is because a year is usually long enough to tell if a particular strategy or employee is working out. If the strategy or employee is unproductive, you cut bait and move on to something that is potentially more productive.

But preserving wealth requires a completely different set of skills, routines and timeframes than it took to create that wealth in the first place. There’s nothing wrong with taking stock of your investments on an annual or even quarterly basis. You just need to be very careful about what you do with that information.

If you followed that business advisor’s strategy, for example, every year, you would get rid of any stocks that hadn’t performed well over the past four quarters. But the performance of a single stock, industry or even sector over any given 12-month period gives little to no indication of what its long-term performance will be, especially if it’s part of a balanced and diversified portfolio.

Regrettably, making bad choices based on faulty or short-term information isn’t unusual in the investment world. Just consider how most people go about making their first (often bad) investment decision: selecting the right manager.

The first thing most investors do is pore over the track records of any mutual fund or investment manager they’re interested in. They diligently check the past three months, six months or even ten years to see if the right person is steering the ship. After all, it’s only common sense that someone who had good results for the past ten years should continue to do well over the next decade or two. Right?

The answer, unfortunately, is all too-often wrong. Some very smart people crunched some very large numbers a few years back, and they figured out how long you need to measure the performance of a particular fund or manager, to determine if their success is the result of superior skill or just random chance.

The number they came up with, for a fund with an average annual standard deviation of 6% relative to its benchmark (the average standard deviation of a Canadian equity fund), was 36.

As in, 36 years. 144 fiscal quarters. 432 months of consistently beating the market, just to be 95% sure you’re measuring skill and not random noise.

I don’t know about you, but for me, 36 years is a long time to wait to find out if you’ve hitched your wagon to the right horse. From an investment point of view, that’s pretty close to an entire investing lifetime. If you pick wrong, there isn’t going to be a whole lot of time left at the end of those 36 years to regroup, and make up for past mistakes.

The worst thing about picking the wrong timeframe or parameters for measuring success is that it can lead to all kinds of counter-productive behaviour. Take the annual check-up approach as an example. If you had been following that advice for, say, the last 15 or 20 years, here’s what your investment lifecycle would’ve looked like.

In the late 1990s, you would’ve sold all of your under-performing gold, oil and banking stocks (we all know what poor investments those turned out to be), and sunk everything you had into the one surefire sector of the time: high tech.

In fact, by the time the 90’s were drawing to a close, close to 100% of your holdings would have been in technology stocks – just in time to watch your life savings get decimated by the guillotine blade that hit technology investors in the year 2000.

If you were foolhardy enough to continue with this strategy, you would’ve taken whatever was left of your fortune and looked for some new powerhouse stock on which to gamble. Based on short term performance, some of the likeliest contenders might’ve been a couple of superstars by the names of Lehman Brothers and Enron.

My advice – to you, as it was to that potential new client – is to learn to ask better questions.

Don’t ask how you can change your portfolio every 12 months to grab a seat on the latest bandwagon. Ask how you can protect the capital you’ve worked so hard to build from the forces of inflation and market volatility, or what will the cost be to maintain your current lifestyle over the reminder of your life.

The advantage of questions like these, is that they can actually be answered. The answers may not be simple. They’ll likely involve certain sacrifices, asset class selections, routines and strategies for avoiding the risks that can occur over longer timeframes. And they’ll almost certainly never tell you what stock will be next year’s top performer.

But what the answers to these kinds of questions will do is give you real information that is relevant and meaningful to you, your family, and your unique goals and circumstances. Because when it comes to investing, the right questions aren’t always obvious. And the answers to the wrong questions can often be fatal.

Alan MacDonald an Investment Advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of "The Copperjar System, Your Blueprint for Financial Fitness" available on Amazon.

For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.

All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

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  • Bruce Johnson
    March 02, 2012 - 20:52

    So, 36 years is definitely unrealistic to see if you picked the right horse. So what is a realistic time period? 3 years? 5 years? 7 years?

    • alan macdonald
      April 13, 2012 - 14:54

      A realistic time frame is 30 years - if you want to be sure you are not measuring statistical noise. This time frame is, of course, impratical. Rather than use a short track record to select a manager or strategy, concentrate on building a reliable investment process. Owning the entire universe of stocks through a series of index funds is an example of a reliable process (if your time frame is long term). The strategy is reliable because the diversification is sufficient to ensure you don't lose your money, and the market beats the majority of active managers so you avoid the risk of picking the wrong horse.