I was having lunch with some friends last week, discussing investments as usual, when one of my colleagues offered up this tidbit to me. I hear this a lot, or at least some similarly structured claim. Another one I hear a lot is “My investment advisor made me $30,000 last year, and he only charged me $5,000!” The problem with these types of claims is that they although they sound great on the surface, they really offer no clue as to how well the person really did. In order to evaluate somebody’s performance, we need a lot more information.
For one, we would want to know how much the investor started with. If my colleague’s wife made that $100K by investing $10M, then that’s only a 1% return. On the other hand, if she started with $100K, then she made 100% — essentially doubling her money. These are two extremely different performance scenarios that lead to the same resulting profit.
Another important data point that we need when evaluating performance is the duration of the investment period. There is a big difference between total returns and a time-adjusted return. The Compound Annual Growth Rate (OTCPK:CAGR) is the annualized return, equivalent to the Annual Percentage Rate (APR) that we all see on our credit card bills. It is calculated by converting the total returns over an investment period to the returns that would have been made over the course of one year. To understand why this is important, we need to simply recognize that making 10% over a one-month period is much better than making 10% over a twelve-month period. In our specific example, we can infer that the investment period was over the course of one year, but it’s certainly not obvious in many cases.
This fudging of returns — by stating total returns rather than CAGR, is one of the biggest lies in investing. Almost every performance number published for investment advisors (or investments) states the total return, not the CAGR. When an investment advisor claims his stock pick has made 25%, he’s usually stating his total return, not the annualized return, which makes the returns seem much greater — and more appealing — to the consumer. It’s important to keep this in mind when evaluating performance numbers.
Another important factor when evaluating performance is the overall riskiness of the investments. The primary way we measure riskiness of an investment is to measure the volatility of the investment, which is the tendency for it’s value to move up or down. If, for example, my colleague’s wife had made $100,000 early on in the year, then lost $200,000, then made it all back by the end of the year, we would probably consider that to be very volatile. If, on the other hand, she made around $9,000 per month, every month, for the duration of the year, we would not consider that to be very volatile. For a rational risk-averse investor, less volatility (or risk) is much more desirable.
And finally, there is one more bit of information we would want to know when evaluating performance numbers — the market returns. The market return is the returns of the overall market. In these modern days, it’s not just enough for an investor to make money, it’s important that they beat the market (both in terms of returns and risk). The reason is that it’s very simple for an investor to simply put their money in a low-cost index fund that mirrors the overall market. If an investor is *not* going to do this, then there must be a better reason, and that reason had better be a betterrisk-adjusted return than the market.
So when somebody says to you that they made thousands of dollars in the market, or that their investment is up 50%, don’t simply take that at face value and think that they did a good job. Make sure to dig deeper to get a better picture of the overall investment performance.