By David L. Allison, CFA, CIPM
For many investors, the biggest challenge of success is keeping quiet about it. With the bull market recently celebrating its five-year anniversary, you probably know someone who is gloating over the investment gains they experienced by speculating in some dark corner of the stock market.
Even if this is not the case, the media have made it crystal clear that most US stock market indices had a banner year in 2013 and continue to hit new highs.
If you live in the United States and do not have a large portion of your retirement funds allocated toward US stocks, then you may feel surprisingly disappointed in your investment returns lately, even if those returns are exceeding the expectations initially set by you and your financial adviser.
As a study published in January titled “Investor Happiness” suggests, extreme stock market outcomes can make investors react to their portfolio returns in unanticipated ways. The study showed that in extreme up markets, investors unexpectedly found higher portfolio returns disappointing, whereas in extreme down markets, investors unexpectedly found lower portfolio returns acceptable.
These findings support the notion that relative returns (your investment returns relative to your peers or the market) likely play an underestimated role in how satisfied you are with the progress of your investments. In addition, investors tend to assign a greater significance to their more recent experiences. So, regardless of how well your diversified investment strategy has worked in the past, it is normal to feel envious when stocks suddenly go on a hot streak and you are not fully participating.
But no one ever retired early or put their kids through college simply because their investment returns outpaced a stock market index. In addition, successful investing requires patience and a willingness to act against the crowd. These two traits are opposites of the herding behaviors brought on by naively comparing your investment returns with the returns of other investors.
If the hype surrounding the recent surge in US stocks has you filled with envy, below are a few simple suggestions that might keep you from questioning your well-thought-out investment strategy at the wrong time.
Avoid Comparing Your Investment Returns with Your Peers’ Returns
You should not compare investment returns with your peers’ returns for three reasons:
- You are not comparing apples with apples. Everyone has unique investment objectives, constraints, and levels of risk tolerance. This makes it nearly impossible to fairly compare investment returns from one individual investor to another.
- Your peers likely are not calculating their investment returns correctly. Consider a study by Markus Glaser and Martin Weber in which they surveyed 215 online investors and found very little correlation between their self-estimated investment returns and their actual investment returns.
- You are probably not hearing the whole story. For example, your friend may claim to have “smoked the S&P 500” in his online trading account, but he may have failed to also mention the much larger 401(k) plan that he liquidated back in 2008 that remains invested in cash.
Do not let someone’s tall tales and shoddy math calculations play games with your mind. The next time your neighbors start boasting about their investment returns, mentally cut their stated return in half and politely change the subject!
Reframe Your Benchmark
Every night, news anchors report on the daily price changes of major US stock market indices, such as the Dow Jones Industrial Average (“the Dow”) and the S&P 500 Index. Rarely will they review the performance of major indices that track the US bond market or any foreign market. As a result, most individual investors default to the Dow or the S&P 500 when benchmarking their investment returns.
But using a benchmark this narrow is not a good idea for many individual investors. Stocks represent only a small portion of the average individual’s net worth, and many investors have some portion of their investment portfolio allocated toward bonds and foreign stocks. In addition, the committees that maintain popular stock market indices are simply managing the index to create a good proxy for large-cap US stocks. They do not have personal investment objectives, constraints, or levels of risk tolerance to consider when making their decisions.
Comparing your investment returns with an incorrect benchmark can lead to such behavioral risks as performance chasing. For this reason, consider working with your financial adviser to create a customized benchmark — absolute or relative — by which to measure the progress of your investments. Doing this will help you focus on a frame of reference that is more in line with your investment objectives, constraints, and risk tolerance.
Evaluate Your Investment Returns Less Often
Keeping tabs on your investment returns is helpful, but it can backfire if it becomes an obsession. When markets become volatile, gauging your returns too often can lead to investment decisions that are based on noise rather than on quality information. Moreover, every time you evaluate your investment returns relative to a benchmark, you run the risk of subjecting yourself to a host of emotions and psychological biases that can lead to poor investment decisions.
Consider a study by Cambridge Associates titled “Manager Hiring and Firing,” which was highlighted in the CFA Institute report “Breaking the Short-Term Cycle.” Researchers analyzed 92 institutions and found that their decision to switch investment managers, often on the basis of short-term criteria, ultimately resulted in lower investment returns.
As illustrated below, the study found that the fired investment managers actually ended up outperforming their replacements about 60% of the time over the one- and three-year periods after they were fired.
So, constantly mulling over your investment returns and making decisions based on noise and emotions will do you more harm than good. For this reason, you probably should not worry about comparing your portfolio’s returns with a benchmark more than once or twice per year at the most.
In conclusion, investing is about reaching your long-term financial goals. It is not a competition between you and a market index or you and your peers. In fact, as an individual investor, the biggest behavioral edge you have over professional fund managers is that your livelihood does not depend on short-term investment performance relative to your peers or a market index. This freedom should allow you to make better, more long-term-oriented investment decisions.
Following the suggestions above will help you avoid getting so caught up in battling with the Dows and the Joneses that you end up losing the war with one of your biggest enemies when investing: envy.