Dangerous Measures: The Fine Art of Calculating Returns

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

The person responsible for translating the math chapter of my book, Wealth Management, into Japanese told me, “You give me much headache.” Welcome to the math chapter.

Okay, class, today we’re going to be discussing one of the most common activities for financial planners, namely, the calculation of investment returns. Accounting in some measurable way for changes in investment values is fundamental to the work of financial planners. It may come as a surprise to you that such a simple concept is fraught with danger. The danger lies in the potential misuse of valid measurements.

There wouldn’t be much room for confusion if there were only one valid measure of investment return. Unfortunately, the mathematics of finance offers many choices. Among the most common are:

  • Current return
  • Total return (holding period return)
  • Real return
  • Compounded return
  • Time-weighted return
  • Dollar-weighted return (internal rate of return (IRR) and modified IRR)
  • Arithmetic return
  • Risk-adjusted return
  • Sharp ratio

Let’s consider each and I’ll simplify the discussion by assuming that we’re referring to the income received for a full year.

Current Return

This is perhaps the most popular measure with investors and some mutual fund marketing mavens. It is frequently referred to as the yield or payout. It’s an attractive measure because it provides a simple measure of the annual payout on an investment.

Dangerous Measurs Chapter Image file - .01

Although simple, this measure has a major problem. Consider the number we use for total income. That single number doesn’t distinguish the nature of the income. Is it interest income or principal payments, or capital gains, or some combination of those? There’s no way of knowing how consistent an income stream will be in the future. I’ll promise to pay you a current return of 20 percent per year as long as you don’t ask me for any money after five years.

Dangerous Measurs Chapter Image file - .02.png

Okay, let’s focus on the interest income. Will that resolve the problem? Not necessarily. The bond fund we’ve invested in may hold many premium bonds. Those are bonds that were issued when interest rates were much higher, so although we receive significant current annual income, some of that is actually a return of principal. When bonds mature they will be paid off at par not at the bonds’ current market premium value.

Now we can talk about some measures that may be more useful.

Dangerous Measurs Chapter Image file - .03.png

This simple measure eliminates potential misleading factors that affect current return, but it fails to answer a number of important questions. Measuring total return is only a starting point in evaluating investment returns.

Real rate of return = Total return minus Inflation rate

Another simple but very important calculation determines what investment advisors call “real return”—how much did an investor actually make after inflation. Earning 10 percent if inflation is 3 percent would be nice, but if a few years later inflation is 8 percent and they’re still earning 10 percent total return, that wouldn’t be so nice. All our clients live in the real world, so all of your planning should be based on an “after inflation” real return.

Compounded Return

Now we’re getting to the number most investors are looking for: “What did I earn last year?” The most common measure is called the Internal Rate of Return (IRR). It’s also known as the dollar-weighted return. This calculation considers the timing of additional investments your clients made and/or withdrawals they took during the year and the return of the investments in the portfolio.

Time versus Dollar-Weighted Return

We’re not done yet, one more to go. The power of IRR to include interim additions and withdrawals from the portfolio is also its Achilles’ heel. If you’re evaluating the performance of a portfolio when you have control of the external cash flows, the IRR provides a valid measure. If you have no control of the external cash flows—when your client adds or withdraws money—you need to consider using two measures. The IRR will provide a valid measure of your client’s portfolio performance; however, it will not answer the question of how successful your recommendations were.

To answer that question, you need an alternative investment-return calculation known as the Time-Weighted Return (TWR). Basically, this measure calculates how the investment would have performed if no new additions or withdrawals had been made during the year. After all, if you and your selected money managers have no control of the timing of external cash flows, your performance should not be penalized (or rewarded) for your client’s unfortunate (or fortunate) investment timing.

For example, consider the results of two investors, each of whom invested in the same mutual fund. Investor A invested $90 at the beginning of year one and an additional $10 at the beginning of year four. Investor B placed $10 in the portfolio at the beginning of year one and $90 at the beginning of year four. Here are the results of their investments:

Dangerous Measurs Chapter Image file - .04.png

So there you have it, two investors, investing in the same portfolio, resulting in six different performance numbers. What do those numbers tell us? The average annual return? Not much. The dollar-weighted return? Investor B was lucky and invested the bulk of his money at opportune times and the advice was credited with a 9 percent annualized return.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Market Timing: A Fool’s Game

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Markets don’t care about what you need.

The Trujillos visited me a few months after the technology market crashed in 2002. They were a lovely couple—both in their mid-seventies—Mr. Trujillo was dapper in his tailored blue blazer, and Mrs. Trujillo was beautifully coiffed and dressed in a lovely St. John suit (my wife’s favorite high-end store). They had scheduled the meeting after sustaining significant losses during the tech market crash. After the traditional introductory “how are you” courtesies, Mr. Trujillo came right to the point.

Mr. Trujillo (T): Mr. Evensky, our investments were decimated in the market crash and we’re desperate to recover those losses. We’ve cut our expenses to the bone. The only basic needs remaining are our club and golf dues and our annual cruise. We’re hoping that you, as a professional, can help us.

Harold Evensky (HE): Mr. Trujillo, I’m sorry to hear about your losses. Perhaps you can give me some idea of how you believe I may be of help?

Mr. T: Well, we thought that by judicious market timing and sophisticated stock picking we can earn returns well beyond what we could by just tracking the market.

HE: I understand. Tell me how you were investing prior to the market crash.

Mr. T: Given the extraordinary returns in technology and all of the news about the new era of the nineties, we were heavily concentrated in technology funds. We recognized the risk of putting all of our eggs in one basket, so we diversified among several well-respected technology funds. For a year, we were doing extremely well; our returns were more than 80 percent. Unfortunately, no one warned us prior to the market crash, and in less than a year our portfolio was down 70 percent! I still don’t understand why we lost so much. It seems that if we made 80 percent and lost 70 percent, we should still be 10 percent ahead.

HE: I understand. Let me do some analyses to see how you’re positioned so I can determine what recommendations may be appropriate. Can we get together next week?

Mr. T: That would be fine.

After the Trujillos left, I gathered the information they had provided regarding their current investments and all of their financial goals. Factoring in assumptions for taxes, future market returns, and inflation, I entered all of the information into our planning software, MoneyGuide Pro, and ran several scenarios with varying allocations between bonds and stocks.

It was bad news: no matter how I jiggled the allocations, my conclusion was the Trujillos could reasonably spend only about one-half of what they considered a bare-bones lifestyle. That’s not the sort of news a planner looks forward to sharing with a client. Unfortunately, although Mr. Trujillo said they needed a return that would enable them to maintain their lifestyle, the reality is that the markets don’t give a damn.

How about Mr. Trujillo’s solution of market timing? As I explained to David Samuel in Chapter 14, “Market Timing for Fun and Someone Else’s Profit,” trying to find the pot of gold at the end of the rainbow is not a viable investment strategy. Unfortunately, their experience with the boom and bust of their portfolio didn’t convince them of the market-timing fallacy. Rather than the impossibility of consistently making the right call on market turns, Mr. Trujillo complained that no one warned them prior to the market crash. He ignored the fact that no one warned him because no one knew in advance. If you think about it, had the impending crash been obvious to professional investors, they would have moved to cash prior to the crash. Of course, they didn’t, and across the board, professionals, including the managers of the Trujillos’ diversified funds, were blindsided, as both investors and professionals have been with every market correction and crash.

You may be thinking about people you know who managed to avoid much of the loss during a bear market, and I’m sure that’s true. In fact, one of the major arguments for active management is that it may not work all of the time, but it comes to the forefront during bear markets because an active manager can reduce his or her equity exposure, whereas an index fund must stay fully invested. Although that statement is true, the conclusion is not.

In 2013, my graduate assistant (who’s now a professor), Shaun Pfeiffer, and I researched this argument. We found two fatal flaws: 1) The majority of active managers did not avoid bear market losses. 2) Even more importantly, those who managed to avoid losses in one bad market generally fail to do so in subsequent bad markets.

As for Mr. Trujillo’s confusion about his loss versus his expected 10 percent gain, it’s a classic—and dangerous—mental math trap. Big losses have far greater ramifications than most investors understand. Suppose the portfolio was valued at $1,000,000 before the big 80 percent gain. It would have grown to $1,800,000. If it then lost 70 percent, the 70 percent was a loss on the $1,800,000 portfolio, leaving a balance of only $540,000! Even worse, to get back to the $1,000,000, the Trujillos would need an 85 percent return. Not likely.

What did I tell the Trujillos? As tactfully as I could, I walked them through the numbers and tried to explain the reality of their financial position. Unfortunately, I was unsuccessful and they continued to insist that having cut expenses to the bone, they would have to simply find someone who could help. I wished them the best but feared they would simply be digging themselves into a deeper hole with progressively less opportunity to at least mitigate the pain.

The moral? Markets don’t have feelings or morals. They do not care what an investor needs and there is no investment or strategy that has consistently provided returns well in excess of those earned in the broad markets. Consequently, if you care about your financial future, don’t base the quality of your life on hopes, dreams, and the expectation of being the first person to find that pot of gold or win the lottery. Do your planning based on the reality of the markets.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Flight to Safety: The Portfolio that Makes for an Uncertain Future

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Certainty Isn’t Safe

Harold Evensky (HE): Kirin, good to see you. Where’s Autumn?

Kirin (K): She’s out shopping. I wanted to see you alone. I’m very upset and concerned about my investments; I don’t want her to know and get worried.

HE: Kirin, what’s worrying you?

K: Well, as you know, most of my money is in a series of large, one-year CDs that I’ve been rolling over every year. A few years ago, I was getting almost 9 percent. It’s been going down every year, and now I’m facing rolling them into CDs that are paying only 1 percent! Harold, we can’t live on 1 percent.

HE: I hear you and, indeed, rates have come down significantly. We might find a bank paying a tad more, but it would be a small increase. Let’s talk about repositioning at least some money into a balanced portfolio.

K: A balanced portfolio? That sounds like it has stocks?

HE: Indeed, the idea is to balance your investments between stocks and bonds—probably somewhere in the range of 50 percent bonds and 50 percent stock.

K: Harold, forget it! The market’s too risky. No way am I buying stock.

HE: Okay, Kirin, let’s talk about designing a laddered bond portfolio.

K: What’s that?

HE: Well, we would buy a series of high-quality bonds maturing each year during a period of time. If you invested $100,000, we might buy ten bonds, one maturing in one year, the next in two years, and so on until the last $10,000 was invested in a ten-year bond. That way, if interest rates go up in a year, you’ll have the money from the maturing bond to invest at the new higher, ten-year rate, and if rates go down, you’ll have most of your money invested in bonds paying a higher return than the current market.

K: Sounds cleaver, but forget it. No way am I tying up my money that long.

HE: Okay, Kirin, I give up. Stop buying your one-year CDs and buy five-year CDs. At least they pay a little bit more.

K: Harold, no way. Long-term to me is a green banana.

HE: [By now, I was more than a little frustrated.] Kirin, go ahead make my day—die. [Normally, I wouldn’t be so blunt, but Kirin was not only a client but also a long-time friend and I thought he needed a significant wake-up call, so I went on.] If you really did die, I would be distraught because you’re a good friend, but what keeps me awake at night and should keep you awake at night is not dying and having no financial assets to support your lifestyle. As my friend Nick Murray would say, your problem is confusing safety and certainty.

CDs are certain in that you can have confidence that you will receive the interest payments promised and your full principal back at maturity. In the real world, the friction of taxes and inflation is likely to result in your certain payments buying less and less. That means your standard of living will gradually be eroded. That is not safe. The moral? Don’t confuse certainty and safety. A safe investment portfolio has a high probability of allowing you to maintain your standard of living. For most of us, that means investing in both bonds and stocks.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Irrational Investing: You’re Not the only One Who’s Nuts

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Good news! You’re not irrational, you’re human.

I just came from one of the most exciting lectures I’ve ever attended. That shouldn’t be a big surprise, because Danny Kahneman, the speaker, is a Nobel Laureate. Professor Kahneman received the Nobel Prize in economics for what has become known as Behavioral Economics. Basically, his studies brought to light the difference between the rational investor—someone who always rationally makes investment decisions in his or her best financial interest—and real people like you and me. We live in a complex world and that’s certainly true of investing.

To manage the complexities of life, we often use something called heuristics to help us efficiently make decisions in spite of complexities. Think of heuristics as mental shortcuts. Most of the time, these shortcuts work out well; unfortunately, they sometimes result in our making decisions that, when looked at objectively, seem irrational. Each of us also comes complete with a bunch of cognitive biases that lead us to create our own reality, which may not be consistent with the real world. Let me share some examples from Professor Kahneman’s lecture.

Built-In Bias

Just after being introduced, Kahneman asked everyone to look at the audience in the room (there were about one hundred financial planners in attendance). After a few seconds of our rubbernecking, he asked us to raise our hands if we believed that the quality of our planning advice is above the average represented by the other planners in the room. Well, surprise, surprise, we were all above average—just like Garrison Keeler’s Lake Woebegone, where all of the kids are above average.

The problem, of course, is that’s not rational. Half of the audience must have been below average. Professor Kahneman explained that as humans we have an innate overconfidence bias that leads us to have confidence in our judgment—a confidence greater than objective accuracy would suggest. How, he asked, might that get us into trouble when investing? Lots of ways.

We are often overconfident in our ability to pick investments or in the abilities of the money manager we love or the ability of financial media mavens to guide us to the best investments.

Kahneman told the audience about the research of Terry Odean and Brad Barber, University of California professors, who studied the trading results of almost seventy thousand households during a six-year period, accounting for about two million buys and sales. They found that investors who traded the most—those with the most confidence and the best ideas—earned an annual return 11.4 percent. The problem was that the market return was 17.9 percent. The professors’ conclusion? Overconfidence in your good idea may be hazardous to your wealth.

The best protection we have against overconfidence is to step back and apply a strong dose of humility and skepticism before we act.

Next, Kahneman put up a slide that looked something like this:

HHTHTTHTTH

TTTTTTTTTTT

He explained that it represented the results of tossing two coins ten times. He and asked which one we thought was the fair coin and which one was bogus. As sophisticated practitioners we knew instantly that the second coin was bogus: Ten tails in a row? Give me a break. In hindsight, I’m embarrassed to say we fell for the heuristic called representativeness. You know the one: if it walks like a duck and quacks like a duck, it must be a duck.

The problem is that the randomness heuristic led us astray. Had we stopped to think it through, we would have realized that getting ten tails in a row is just as random as the first toss series; the problem was it didn’t look random. Our brains, knowing a coin toss is random, took a shortcut and concluded that toss one looked random so it was authentic; toss two was obviously not random, so it must be bogus.

How can that get us in investment trouble? Ever consider investing in a fund with a Morningstar rating of less than four or five stars? Probably not; bad mistake. Use the star information as one element in your selection process, but the Morningstar ratings are not guarantees of future superior performance. You need to do a lot more research than simply defaulting to the stars as the sole selection criterion. Doing so puts you at serious risk of picking a loser and rejecting a superior investment.

Muddled Math

Professor Kahneman also introduced us to the work of Professor Dick Thaler on mental accounting. It seems that in addition to occasionally being misled by our heuristics and biases, we also stumble over what would seem to be simple math. I know this from personal experience with my clients. I remember having a visit after the tech bust from a retired surgeon, who came into my office almost in tears.

“Harold, I don’t understand. Last year I made 80 percent on my investments and this year I lost only 60 percent, yet my statement says I’m way under water!”

My client’s mental accounting told him that a gain of 80 percent less a loss of 60 percent should leave him 20 percent ahead. The reality was that his original $1,000,000 investment grew 80 percent to $1,800,000, so his 60 percent loss was on $1,800,000, for a loss of $1,080,000. The end result? A balance of $1,800,000 less $1,080,000 left him with only $720,000. It was a painful way to learn that big losses take much bigger gains to recover.

Consider, for example, a volatile investment of $100,000 that loses 50 percent the first year, leaving you with $50,000. Suppose the next year you make 50 percent, so your average return for the two years is 0 percent. Did you break even? Nope. Your $50,000 grew 50 percent to $75,000, leaving you $25,000 under water. Remember that the next time you want to risk funds in a high flyer.

Framing

Kahneman presented much more on the problems investors face because we’re human and not necessarily rational. Then he provided us with the hope that we might help our clients (and ourselves) be better investors through the power of framing.

Framing has to do with the idea that the way people behave depends on how questions are framed. Suppose I offered you two brands of chocolate bars. One was 90 percent fat free and the other contained 10 percent fat. I’ll bet I know which one you’d chose. Have you looked for prunes lately? You may have trouble finding them unless you look for dried plums. The Sunkist marketing department understands framing.

How can you use this technique to be a better investor? Here are a few ideas:

The next time your neighbor gives you a hot tip, instead of focusing on all the good things that might happen, reframe your focus and ask yourself what might go wrong. My partner, Deena, once helped a client make an important decision by pointing out that if she made the significant investment she was considering and it succeeded, she could increase her standard of living by 10 percent. However, if it didn’t pan out, she would have to work four years beyond her planned retirement date to make up for the loss. She passed on the opportunity. She may not have made a killing and missed out on taking a world cruise, but she was able to retire just when she wanted to.

Reframe your performance-evaluation horizon. Investing for retirement is investing for the rest of your life, so when evaluating your investment’s performance, keep your eye on the long-term, not the daily market gyrations. That means skip the comparisons to last month, last quarter, or year-to-date performance and look at performance over years and market cycles. Also, reframe your benchmark. You might compare your large-cap core manager’s performance to the S&P 500 but not to your portfolio. Instead, consider using a real-return benchmark—compare your portfolio return to inflation. After all, that’s what your plan should be based on.

Are you holding a position in a stock at a big paper loss, but you’re reluctant to sell because then it would be a real loss? If I asked you whether you’d buy that stock today, you’d tell me I’m nuts. You wouldn’t touch that dog with a ten-foot pole! Let’s reframe your decision. Since the cost of trading today is negligible, you could sell your investment tomorrow and have the cash proceeds in your hand almost immediately. That means by holding onto your stock, you’ve made the decision to buy it again!

The moral? We’re human, not rational, and recognizing reality and learning about some of the problems our biases and heuristics get us into and using framing to help manage these risks will make us far better investors.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Asset Allocation: The Myth of the Portfolio that Acts your Age

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Policy research is great for policy makers but may be poison for you.

I just finished reading an article in a professional journal that reported on extensive research about how people of different ages divide their investments between stocks and bonds. It went something like this.

Our research, based on zillions of responses to trillions of questions, has determined that investors at age forty have 60 percent of their funds in stocks and 40 percent in bonds. Investors at age seventy have 70 percent in bonds and 30 percent in stock. Further analysis, to a high degree of statistical significance, has determined these proportions are close to the proper allocation of resources for the average investor of these age groups.

 Therefore, we have concluded that, based on our studies, investors should use the following formula to determine the percentage of stocks and bonds in their portfolios:

  • The amount to be invested in stocks = (100 – the investor’s age)
  • The amount to be invested in bonds = (100 – the amount invested in stock)

What a terrific solution to how you should invest your money. No muss, no fuss. All you need to know is your age and the rest is just simple math that you can do in your head. If that seems too easy, there are many companies and magazines that provide more detailed suggestions about how to invest your money based on your age. All of these approaches are based on a concept known as life-cycle investing. The general idea is that your financial needs are related to your age. The approach is endlessly popular and sounds terrific. There’s only one problem: it’s hogwash!

Wait, that’s not fair. If you happen to be a sociologist or a government policy maker, this might be terrific stuff. After all, sociology is the study of large groups. Still, it’s dangerous hogwash if you try to use it to plan your own life. Remember, sociologists are the professionals who came up with the concept of families with 1.8 parents and 2.3 children.

Since you’re probably not a sociologist or policy maker, and are more interested in your unique needs than the statistically average needs of everyone your current age, the cookie cutter—life cycle approach—to planning won’t work for you.

Let me tell you about two of my clients, the Salters and the Boones. When we first worked with them, my partners and I were amazed at how similar these two families seemed. Both families not only live in the same city, they also live in the same neighborhood, just two blocks apart, in houses of the same model, built the same year by the same builder. Mr. and Mrs. Salter and Mr. and Mrs. Boone are working professionals. When we met them they each were fifty-five years old, in good health, and they planned on retiring when they reached sixty-two. The coincidences seemed endless. We thought they even looked alike! Both had investment portfolios valued at $1,000,000 at that point, and they all considered themselves moderately conservative investors. Because neither the Salters nor Boones have children, they have no desire to leave an estate.

Well, if lifestyle planning worked, these two couples’ investment portfolios should look alike. Lucky for our clients we are financial planners and we gathered more information. Here’s what we discovered:

Asset Allocation Chapter Image file - .01

How about that? To a sociologist, these couples looked alike; to a financial planner, based on their savings rate, their retirement income, and financial goals they looked very different. Let’s see how our recommendations differed from the life-cycle solution.

Asset Allocation Chapter Image file - .02.png

Note that the life-cycle recommendation is the same for the Salters and Boones. That seems a little strange because the Boones plan on spending a lot more than the Salters in retirement, and the Salters are saving more between now and retirement and have significantly more Social Security income. The fact that their ages, risk tolerance, employment, home, health, and planned retirement dates are similar is irrelevant.

After careful analysis and based on the information specific to our clients, we made the following recommendations:

Asset Allocation Chapter Image file - .03.png

It sure doesn’t look like the 55 percent bond formula you’d get by subtracting their age from one hundred. Why the difference? In spite of similar demographics, the Salters and Boones have very different resources and goals. Remember, you’re unique and planning based on simple rules of thumb can be a mighty dangerous way to plan the quality of the rest of your life.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.