All returns are not created equal

In my last two blogs, I wrote about 1) measuring what matters most: after-fee, after-tax returns and 2) capital preservation: maintaining purchasing power as the prime directive of investing.

Now, I want to bring those two thoughts together with a third: all returns are not created equal. 

Just as investors place undo emphasis on 1) tax avoidance and low fees instead of actual returns, and 2) volatility and "safe" securities instead of the risk of permanent loss and after-inflation purchasing power, I believe investors also commit a third sin: 3) undo emphasis on returns earned over some arbitrary period instead of the process by which those returns were generated.

A quick example here should illustrate my point.

Suppose you were given the choice to invest for the next 10 years with two money managers: Firm C or Firm M.  Suppose, too, that you were presented with their 5 year investing records: Firm C: -6% loss over 5 years; Firm M: +6% gain over 5 years.

For most people (and for me in the past), this is an easy choice.  Over 5 years Firm M has earned a positive 6% return and Firm C has lost 6%, so go with Firm M, right?

But, wait!  How were those returns achieved?  Let's examine each firm's annual returns over the last 5 years:

• $100,000 invest with Firm C
• Year 1: -4.5%, $95,500
• Year 2: +1.0%, $96,500
• Year 3: +1.0%, $97,500
• Year 4: +1.0%, $98,500
• Year 5: -4.6%, $94,000
• $100,000 invested in Firm M
• Year 1: +4.5%, $104,500
• Year 2: -1.0%, $103,500
• Year 3: -1.0%, $102,500
• Year 4: -1.0%, $101,500
• Year 5: +4.4%, 106,000

See anything funny, yet?  Don't worry, I wouldn't have, either.  Let me explain how those returns were achieved.

As a thought experiment, I put these two investing firms against each other.  Each year, one bets $1,000 that a 6-sided die will land on 1 and get paid $4,500, and the other takes that bet (hoping the die lands on 2 through 6).  In my example, Firm M is making the bet and Firm C is taking the bet.

Now, perhaps, you're not so sure you want to invest with Firm M!  Sounds more like gambling than investing?  Yes, precisely. 

Each year, Firm M has a 1-in-6 chance of gaining $4,500 and a 5-in-6 chance of losing $1,000.  Although Firm M's investing record looked pretty good over the last 5 years (because the way the die just happened to roll those 5 times), you may not feel too comfortable now that you know how the return was generated. 

In fact, the next 10 years have a very high likelihood of Firm M losing 4.2% a year and Firm C gaining 4.2% a year.  That's where the firm names came from: M is for Madoff and C is for Casino.  The odds were on the casino's side all along, even though the record looked bad over those five years, and the odds were always against Madoff.

And, that's the point I'd like to make.  Most investors look at an investing record and believe past is prologue.  But, the past is rarely the best judge of the future.  Instead, the right way to judge returns is by examining the method used. 

Two investing firms can have the exact same investing record, but one can generate returns by taking bad bets (and getting lucky) and the other by taking good bets.  You need to figure out which firm is taking good bets to generate satisfactory returns in the future.

This is particularly the case today.  Some firms have deceivingly weak records over the last several years because they've taken smart bets and the die has rolled against them.  Other firms have brilliant-looking records although they've taken bad bets and the die has rolled in their favor. 

Only by looking behind the curtain will you see if there is a real wizard or a blathering fake.  It may seem trivial or time-consuming, but understanding how returns are generated is much more important than the return record itself--future returns will depend on it (as Madoff so ably illustrated).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.