Are you trying to keep up with the Market Joneses? Forget about the benchmark and focus on your goals
By Trevor Geffin
Ask yourself, why do I get up every morning? Work 8 hours a day, 5 days a week, 52 weeks a year; and do this for 40 years? Then ask yourself, I have sweat blood and tears over my career, what is the purpose of these fruits of my labour and my wealth? Why do I accumulate it and what am I going to use it for?
These are the important questions that we all need to consider at some point and how you chose to address them will impact how you plan and live your life; and subsequently the goals you achieve as a result of your investment endeavours.
I am almost certain that after considering these simple but core questions, that you do not believe the purpose of your wealth is “to make sure I obtain a rate of return greater than the an index” or “to make sure I also invest in the small cap mutual fund my friends successfully invested in, that returned 20%”, but something more along the lines of common goals expressed to us by our clients:
– “I want my money to work for me while I sleep, so I don’t have to”
– “I don’t want to worry about whether I have enough for a rainy day”
– “I want to secure my children’s future by giving them a head start in life”
– “I want to go on an overseas holiday every year and see the world”
– “I want to have a passive income from my investments, so I can have more time for a hobby”
– “I want to make sure my income will last throughout my retirement”
– “I do not want to be a financial burden on anyone else especially my kids”
– “I want to have the freedom to spend money without having to think can I really afford it”
– “I want to have the option to take it easier as I’m older and reduce my working hours”
– “I want to give money to charity and help my community”
– “I want to live in a nicer home that suits my life style”
“If this is the purpose of your money, then how do you best arrange your wealth to ensure that you give yourself the highest chance to achieve your aspirations?”
If you were to measure how you were tracking towards achieving these goals, what would be the best method of doing so? Seemingly your success in relation to these goals cannot be determined by comparing the performance of a portfolio to a few hundred large companies ranked by their size, such as a benchmark like the ASX200 or S&P500. It certainly seems odd that one would adopt such a frame of reference when it has almost no relevance to those very pertinent questions.
The question about measuring the value you receive from your portfolio is not only a philosophical one but is also a matter of relativity. As an investor you obviously seek to achieve the best return possible given the cards you hold, however the key questions that must first be answered is relative to what? Is it a return better than the market? Or a return better than my neighbours? Or better than the top 50 stocks? Or maybe the top 1000 global stocks? Or maybe some combination of all of them? And to even complicate things further, over what time frame? 1 day ? 1 month? 1 year ? 5 years?
What is an index anyway?
Josh Brown from the Reformed Broker give us a very useful reminder that “Indices, we ought to remind ourselves, are human constructs. They were not handed down from atop Mount Sinai nor are they naturally occurring phenomena. They’re lists of stocks and amounts cobbled together by a very human committee and, as such, should not be worshipped as the end-all, be-all of investment allocations.” – Reformed Broker
Have you ever asked considered why we analyse the ASX 200 and not the ASX 212 or ASX 232? These are very arbitrary human designs.
If we take a broad based index like the well-known ASX200, what we are looking at is a performance of the 200 largest firms on the Australian stock exchange weighted by how big they are i.e. the bigger the company, the higher its percentage in the index. For example, below are the 20 biggest index constituents of the ASX200, which represent a whopping 57% of the index.
By measuring your success against an index such as this, you are essentially seeking the answer to life’s very important financial questions largely based on the performance of these 20 companies. Whether an index is up or down relative to your portfolio has become an obsession for investors and investment professionals alike. We believe this manner of measuring your success is abstract, impersonal and largely irrelevant in helping you understand where you need to be to achieve your goals and if you are getting closer to the life you want to live.
Even achieving an index performance is beyond most investors
A fascinating study performed by Dalbar, a US based research company, annually measures the typical investor’s return versus a variety of market indices. The results are consistently alarming for investors where a measurable “behaviour gap” is identified in investor returns.
The behaviour gap in this context, is the gap between the return investors’ actually achieve and the investments they are invested in. The difference in return is referred to as the behaviour gap, as the underperformance is caused by investor behavior (i.e. their own buying and selling) and not the investments themselves, because if you hold the investment you cannot underperform it.
“To put these figures into perspective, if you invested $100,000 per annum for 20 years at 7.68%, you would have $439,239 at the end of twenty years, quadruple your wealth. If instead your earned 4.79% pa for 20 years the investment would be worth $254,916, a difference of $184,323, which is the behaviour gap.”
Why is the behaviour gap a universal phenomenon?
The behaviour gap is largely created through the investors propensity in relation to their own investments (which may even be an index) to sell low and buy high, instead of the other way round. We can all think of an investment decision we have made on our own, only to see the stock we have just sold go up in value or a stock we have just bought lose value.
Behavioural economists and psychologists have identified 100s of different emotional and behavioural biases, that impact all market participants (including professional investors) which lead to this behaviour. Nobody is immune either, as these behaviours and mental shortcuts are hard-coded into our psyche via evolution in order to assist us in quickly making decisions and solving problems in hostile environments.
Notable behavioural bias impacting the investor are the herding effect and loss aversion.
Herding refers to the propensity for investors to follow what everyone else is doing, leading to a buy high/sell low outcome. This is because investors only react after the fact and buy securities once they have been pushed up to high valuations by other market participants all rushing in at the same time . The markets obsession with indices as a manner of measuring performance pours fuel on the fire as index performance is published and available 24 hours a day, minute by minute. Constantly being bombarded by a rising stock market is an effective method of making us feel as though we are missing out, prompting us to feel the need to buy or we’ll miss the train. And too often investors are jumping on the train as the conductor is pulling out.
Another notable bias is Loss aversion. This refers to a situation where the fear of losing wealth leads to a withdrawal at the worst possible time. For fear of experiencing paper losses investors tend to sell as a market crashes and buy back late in the recovery, leading to significant capital destruction.
The focus on beating benchmarks is a culprit leading to the behavior gap, because every minute of the day you are encouraged to make decisions in order to keep up with the market and minimise regret, which is counterproductive to your personal goals.
” In reality the participants in the market, the very people who drive the performance of the benchmark have goals and timeframes that are totally at odds to you.”
You have high frequency traders who are concerned about what they market is doing in the next 10 secs, stockbrokers who are trading daily, buy and hold investors who are investing for 20 years and on it goes. The market is essentially an average of these opposing timeframes, of which you are a small input, and you are often the last to know any information.
In fact, market crashes are an inherently psychological event and it often comes as a result of one significant pocket of market participants having timeframes at odds to others or rapidly changing their timeframes and acting on it i.e. a large section of the market who are looking to make short term profits, can tank the price of a stock you have invested in for the long-term as they decide to allocate their capital elsewhere also for short-term gain.
You will never beat the index you see in the news.
Published indices should come with a disclaimer:
“The reality is that you can NEVER beat a “benchmark index” over a long period. This is due to the following reasons:
1) The index contains no cash
2) It has no life expectancy requirements – but you do.
3) It does not have to compensate for distributions to meet living requirements – but you do.
4) It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
5) It has no taxes, costs or other expenses associated with it – but you do.”
Source: Realinvestment advice
What is the solution?
Investing in markets can be very stressful and we know that all our investors prefer a strategy which has less stress or to be more precise, less volatility. However one of the most ineffective methods of reducing this stress is by following the herd, setting your goals in relation to what everyone else is doing and then acting on it.
Your retirement, lifestyle and income needs really have nothing to do with the needs that the general public is trying to achieve through their investments. When viewing your portfolio performance through the prism of a benchmark, you are consistently doomed to be dissatisfied with your portfolio even if it is letting you live the life you dream of.
“Comparison is the enemy of satisfaction and no matter how good your portfolio performs, you will always find one that has performed better, 100% of the time.”
David Snowball gives us a poignant reminder; “Focus on what’s meaningful: are you making steady gains of the sort that will allow you to enjoy life, to make a difference in the world, and be rich with friends and family? If so, you’re winning. Celebrate.” – David Snowball
By trying to continuously beat a benchmark, you will constantly be transforming your victories to defeat i.e. the achievement and fulfillment of your lifestyle goals become a disappointment, as you underperform the herd of investors during an arbitrary time period and through an arbitrary collection of stocks called an index.
The round the clock availability of the index will constantly remind you what you are missing out on (until the market crashes, which is when a properly diversified portfolio outperforms), whereas you should be focusing on how to use that index in your portfolio to help you reach your personal objectives. If you are building a legacy for your children, saving up for a holiday home , looking to purchase homes for your children etc, what do you care if 5 banks, 2 miners and a couple of oligopolies generated in returns over the last 3 months?
A useful antidote to avoid the traps of the behaviour gap is to ditch the benchmark and focus on your goals.
This epiphany will liberate you as an investor as you stop being concerned about monetary policy, fiscal policy, Donald trump, interest rate directions and the next market crash. The only things that matter are the stability and outperformance of your own economy, the only one that matters to you.