The Consequence Of Misinformation In Assessing Investment Performance

 

At the end of the year we looked at Why Year End Investment Results Don’t Matter. In the post I had discussed why conventional portfolio and investment evaluation metrics are not meaningful, because they are not relevant and not accurate. Investors should not rely or pay too much attention to them. To summarize, conventional methods for evaluating the performance of a portfolio and investments, are based on the calendar and the market price, and therefore they do correlate to any of the factors that would actually be relevant or related to the investments themselves. I will continue that discussion in the next two posts. First, I will present a deeper understanding of the real issue behind the problem. It’s not just the use of wrong metrics! In the second post, I will discuss more meaningful methods and a better way for you to evaluate the performance of investments.

 

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Two Crucial Factors

There are two crucial factors that come into play when evaluating the performance of investments. They are (1) How to tell if an investment is actually doing well or not, and (2) How not to be automatically disappointed when you see a negative price change (as the change isn’t necessarily an indicator that an investment is doing poorly).

 

I believe these are two crucial factors in investing that will help you leap forward, but more importantly avoid the failure experienced by the majority. Failure in investing, means continually losing money over the long term. The two factors are related, and ties together both knowledge and practice.

 

These factors sound really simple, yet so many people overlook them and are detrimentally influenced by misinformation. To help you overcome this, I’ll break down the problem, then empower you with knowledge and give some practical methods you can use. The knowledge part is first recognizing and acknowledging that this is actually an important problem (the negative consequences). Most investors will assume they already know how to determine if their investments are doing well, and will stop listening. Secondly, it is understanding the reasons behind why and how it happens. Thirdly, it’s knowledge on the solution, which is the correct thinking and how to avoid the problem. The practical methods are indicators and techniques that you can apply.

 

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Looking For Feedback

Everyone needs some kind of feedback in order to become better investors, and in doing so it’s only natural to look for indicators that may tell you if your investments are performing or doing well. One form of feedback is from another person, either from a guide (in this case me) or your peers. However, another form of feedback is how you fare with your investments, which is something that looks to be seemingly available at any time. It is this later form of feedback that causes problems, especially with stocks (equities).

 

The Consequence Of Misinformation

During your investment career you will make mistakes, even when you are a seasoned investor. It’s unavoidable. The key to avoiding huge and frequent mistakes is being able to differentiate between what is a mistake or poor performance, and what is simply just a difference between the market price and your acquisition price.

 

At the beginning of your investment career you may not be confident enough, nor knowledgeable enough, to determine the real status of an investment that you hold. You would be more vulnerable to being fooled into thinking that an investment is bad or performing poorly, when it is actually not. Investment decisions are then made on wrong assumptions, misinformation, or confusion. This misinformation can then steer you away from making good decisions going forward. How? Because as humans we are all susceptible to backwards looking information. That is, thoughts & memories that are most easily recalled, and thus heavily influenced by recent or vivid events. For most investors, such recent or vivid memories may include disappointment from an investment you are already holding that is “in the negative”, or past investment losses. This then leads to hesitation to act on new opportunities (even if they are solid ones) or being discouraged from looking for opportunities all together. This can even go as far as discouragement from investing in general, keeping you half in and half out. Just when you might be at the cusp of success, you can slide back into the abyss of the average investor (which has a track record of losing money).

 

The majority of investors go on “investing” for years like this, remaining essentially stuck in their investment career even after decades! This hurdle can then prevent you from achieving success and generating serious money. When I say success, what I mean is with consistency over a long period of time, and through both market rallies as well as crashes/declines. The consequence of being stuck making poor decisions, is mediocre profits, but more often it is losses!

 

Unfortunately, that is the norm. That is exactly how not being able to tell if an investment is actually doing well or not, and the automatic disappointment from price changes can lead you down the wrong path and hold you back.

 

The Reason Behind The Misinformation

Now we need to understand the reason behind why investors are getting wrong feedback from the investment itself. The short answer is bad habits formed by years of brainwashing and the wrong mindset!

 

When we look at an investment to see how we are faring, we all want to see some indication of good performance. But what is an indication of performance? When you sell a stock, performance is measured by the percentage gained on the change in the price, plus all dividends collected. This is called the return.

 

But what indicator of profitability should we use when we are not ready to sell, and have no intention to do so in the short term? As Buffett reminds us, when investing in stocks, the minimum time horizon should be 5 years. In many cases the time horizon is even longer. What should we be looking at in the meantime?

 

Everyone has been told by the “experts” of the financial industry & Wall Street, to look only at the change in the stock price as the sole indicator of investment performance. They do this while utilizing the terms “conservative”, “patience”, and “long term”, as buzz words. Then they hypocritically turn around and recommend checking your “returns” periodically at the end of every each month, every quarter, and every year. Over time, they ended up changing the mainstream definition of “returns” to mean the temporary change in market value (i.e. price changes of the investment), even though you haven’t actually sold anything!

 

Whether intentional or unintentional, is another matter to which there are many opinions, but this brainwashing has gone on for years. Like Pavlov’s dogs and the bell, the masses have been conditioned with this wrong mindset. A negative difference in price is immediately interpreted as signs of bad performance, or of a bad investment. A positive difference in price is immediately interpreted as a sign of good performance, or of a good investment. Since stock prices change on a daily basis, the effect is worsened, and has taken investors on emotional roller-coasters. Now, you can imagine the impact of always having this frame of mind when making important investment decisions!

 

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Knowledge & Practical Methods

The bad habits and wrong mindset which have been formed over many years were constantly reinforced by the industry. But the good news is, that like any habit it can replaced with positive ones and a new mindset. Through knowledge (which you’ll have by the end of this discussion) and with continual rational thinking (practice), a re-framing of the way you think about equity investments will be used to form new habits to overwrite the old harmful ones.

 

At this point, we’ve now discussed most of the knowledge part, which are being aware of the problem, the negative affect it can have, and understanding why it happens. The remainder of the knowledge is what to do about it.

 

By far the biggest hurdle is dealing with disappointment. But in dealing with true disappointment, we need to cut away things that confound the issue, most of which are interrelated.

  • The first is your expectations. Expectations need to be realistic and aligned with the specific investment & investing activities. They also need to take into account the time horizon of the investor and of the investment. Most investors expect profits in less than 5 years, when a minimum of 5 years is more realistic for stocks. This is especially true when you are learning, and in the asset building phase of your career. It takes time. Investors also expect linear results, when in fact results in the real world are lumpy and uneven. There will be dips, steep declines, but also rapid or large spikes.
  • The second is making sure you get disappointed with the right things (i.e. what and when to be disappointed). Most investors tend to get disappointed over the wrong things, which is also related to expectations, but also to not knowing what to look at to gauge performance. This is where the techniques & tools come into play.

 

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With the right mindset in hand, you will be able to effectively use the techniques and tools for gauging performance that will be highlighted in the next post!

 

Thanks and Happy Investing!
* The *
* Investment *
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© 2015

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