I’ve been asked a lot of difficult questions by potential investors and clients over the years. But my least favourite has to be: “What’s your one- (or three-, or five-) year track record?”
Just the other day, I was invited to submit a proposal for the opportunity to manage a small endowment fund. There were a series of questions I had to answer and numerous criteria I needed to satisfy. Most of it made a lot of sense, and spoke to the knowledge, tools and experience needed to invest successfully for the long haul.
Then suddenly, there it was: a request for my one-, three- and five-year track records for portfolios with similar sizes and mandates. Seems like a reasonable question, right? It might well be – except for the fact that there is one very big problem with the conclusions that are often drawn from any answer to it.
In Zen Buddhism, the old masters teach their young students that most of the time we spend trying to find the answers to our questions is wasted, because the real problem is that we’re asking the wrong questions. If your question is wrong, no matter what the answer is, it isn’t going to be of much help.
This applies just as well to managing a stock portfolio as it does to contemplating the Buddha. And if you ask me, that short-term track record question would probably earn most of us a good hard whack from our Zen master’s cane. Why? Because the answer to that question won’t tell you anything of any real use or value. It is a statistical irrelevancy.
Let me explain. Let’s say you were flipping a coin. If you flip it a few million times, you’ll get heads half the time and tails half the time. Pretty much guaranteed. But what if I asked you what your track record was for a single flip? According to that time frame, you’d have a record of either 100 per cent heads, or 100 per cent tails.
How about if I asked you to flip the same coin 10 times? Or 100? There’s still a very good chance your results would fall well outside the 50/50 statistical average, because the sample set is still just too small. To put it another way – we all know that there’s precisely a 50/50 chance we’ll get heads or tails when we flip a coin. Flip enough coins, and you’ll get exactly that same 50/50 split. But to get there, you may have to go through a whole string of 60/40, 75/25 or even 90/10 red herring data sets along the way.
When it comes to stock portfolios and mutual funds, most investors are similarly looking at data sets that are simply too small to yield any real conclusions. They are, in effect, observing ten flips of a coin from one manager, comparing his or her results to another manager who is also flipping their coin ten times – and then deciding to put their money with whoever got the most heads out of their last ten throws.
The one-, three- and five-year track records fall into this same statistical trap. The time periods are too short to draw definitive observations about whether or not the manager behind them has the skills and approach we’re looking for, or whether they just happened to get lucky. Too often investors commit their life savings to whichever fund had the highest return last year (or last quarter), only to be disappointed when the results return to average (or below) the next year.
The obvious question then becomes: “okay, smart guy, if five years is too short, then what is a reasonable number?” There is an answer to that. But don’t look at the mutual fund industry to provide it. There’s a reason why every bank has 30 different mutual funds. It’s the only way they can ensure that at least a few of their funds will “outperform” each year, and you can bet those outperformers will be the same funds that get relentlessly marketed as your next big portfolio savior.
No, for the answer to the timeframe question, we have to look to the world of academia, where questions like this are mulled over by some of the smartest people on the planet, and then rigorously tested by statisticians who don’t have any axes to grind.
One such “grind-free” academic is Eugene “Gene” Fama. Gene won a Nobel Prize for his work in the area of finance. And he has determined that you need about 20 years of investment observations before you can be sure you have enough coin flips to start drawing some useful conclusions.
This 20-year timeframe really rings true when you look at the 20-year track records of those few mutual funds that have been around that long. As soon as you get out to the 20-year mark, you begin to see that their track records are almost universally below the average return of the market. This makes sense, given that mutual funds charge a lot higher fees than the market does. Sure, a handful of those funds did outperform the market. Unfortunately, whoever was managing them is probably already spending their days sipping Mai Tais on their private islands.
So what are the rest of us supposed to do if we can’t just go to Morningstar, plop our money down on a bunch of five-star funds and wait for the high returns to start rolling in? Well, for one thing, we can start by trying to come up with better questions.
Instead of looking at one- to five-year track records, for example, we could begin to ask things like: “how reliable will this investment be in capturing the market’s return?” “How well will my personal objectives be served by this investment?” Or “what is this manager doing that’s different from the market, and what specific risks are they advising me to take?”
With questions like these, we’ll at least give ourselves a chance to avoid the Zen master’s cane – not to mention the much more painful swats that real life can bring.
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.
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. Past performance is not indicative of future results.
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.