What is investing success? How do we know when we’re doing really well?
Most of us would say that success is when our investment returns are better than whatever we choose to compare them to. We may compare them to a specific benchmark like the S&P500, or to how others around us doing, but no matter what, we love to compare. When we read about a hedge fund with astounding 9-month returns, we feel envy. When we find out later that the tables have turned and we now are beating that same hedge fund, we feel fantastic. Yet we never ask whether it’s meaningful to feel so awful or great.
Equating success with relative outperformance is something so deeply ingrained and enduring for us we don’t question it. And yet, according to a new study from State Street’s Center for Applied Research called “The Folklore of Finance,” it is wrong and dangerous.
Why so? Because when relative outperformance becomes our one dominant goal, it leads to the kind of bad behavior that ironically destroys return. It makes us focus on the short term and choose investments based on past performance. We forget that things don’t go in a straight line and lose our nerve about staying the course. And when we abandon our long-term plan, it really hurts our returns.
According to “The Folklore of Finance,” it’s not that relative performance is unimportant, but that what’s more important is how we are doing on the personal long-term financial goals we set for ourselves, sustainably, over time. Unfortunately, this is something that’s much harder to measure. Metrics don’t come in a single easy-to-digest percentage return number, and the goal spans a much longer time period than a quarter, a year, or 3 years.
Among individuals, 73% say they invest in order to achieve long-term goals like a comfortable retirement or leaving an inheritance, but only 29% define success in terms of those goals. The vast majority define investment success in less realistic terms like “making gains and no losses.” Among institutional investors, only 22% define success in terms of their long-term goals, while 63% say the top measure of success is risk-adjusted returns relative to a given benchmark.
But outperforming is hard – there’s just no getting around that. And index investing isn’t the answer to it all either. According to Suzanne Duncan, who headed the study, indexing alone is too simplistic a response. It doesn’t change bad behaviors, like market timing, and it doesn’t help investors refine their goals or give them the skills to make good decisions. The State Street study found that a staggering 93% of investors believed they should take matters into their own hands and make their own decisions, but that the majority weren’t prepared to do so. Without the professional toolkit that helps one do everything in one’s power to achieve personal goals, the study said this would be like handling your own toothache with a pair of pliers. And as behavioral economist Daniel Kahneman has said, the two things we often forget are, “We can be blind to the obvious and also blind to the blindness.”
We’re not trying to downplay performance as unimportant here– or to say things are hopeless. We think both absolute and relative returns are important. And while we know it’s hard, we very much believe in outperformance. But interpreting investment returns is so complex and nuanced that it makes no sense to base important decisions on a single number. What is really important is for investors to remember the big picture: Are we beating inflation? Are we preserving enough purchasing power to fund retirement? Are we able to sleep at night with the risk we’re taking?
In the end, investing is not about picking big winners. It’s about using all the tools at our disposal to meet goals, and yes, it’s hard work. So this year, as you reflect on your resolutions, remember why you’re involved in this crazy investment game at all. Know yourself, know what you want, and above all, stick to the long-term plan. Happy holidays.