Investment returns vs Investor returns – The human performance penalty
Allow me to cut through the foreplay and get straight to the point. What we are discussing today is something very crucial to all investors. The topic today is about Investor Returns.
Now we all know what returns are. It is an indication of how hard our money is working, of how many percent we have eked out from the markets. It could the interest from fixed deposit accounts, the coupon payments from bond subscriptions, dividends from REITS, capital gains from stocks or even the difference in price between what we paid for and what we sold our gold hoard for.
Positive returns makes us happy, negative returns makes us want to do this.
In the simplest form, investment returns is net profits divided by total assets. For simplicity sake, let us take the example of Apple Inc (AAPL).
Assuming you have purchased one share of AAPL on 31st May 2011 (first day on the chart) for $49. And you have decided to sell it last Friday for $100. Your returns on that investment would have been 105%. Awesome returns on first glance.
To find out your yearly returns over the previous five years, we use a simple Compounded Annual Growth Rate (CAGR) calculator. It clocks in at 15.3% per year. Respectable returns indeed, I will take that any day.
What we have just calculated is the Investment Returns. In this case, it is also the Investor Returns. As you would have noticed by now, Investment Returns can only be achieved with a one time buy and hold strategy. Unfortunately, few investors operate that way.
What is more likely to happen is that an increase in Apple price will bring about renewed interest in the stock. This is accompanied by an increase in trading volume and various analysts will be clamouring over themselves to write good things about it.
Having already owned the stock, and having seen its meteoric rise in your portfolio, you would choose to seek out confirming evidence and read nothing but justifications as to why it is such an excellent stock to own.
Comes a day when you are certain that Apple can do no wrong, you went out and bought another share. Let’s call that day 18th May 2015. Unfortunately a situation we are all rather familiar with arises. The price begins to decline almost immediately after your purchase.
Your simple returns on this one investment now becomes [(100 + 100) – (49 + 132)] / (49 + 132) = 10.5% over five years. (IRR in case the geeks are reading is 4.7%)
There remains little argument that it has now become a rather pathetic investment. Have you left the money in a fixed deposit account, the returns might have been better.
In this case, Investment Returns and Investor Returns becomes radically different. The difference between the two lies in the human intervention in investing.
I picked the all time high in order to accentuate the difference between the two but even if I were not to do so, Investor Returns will lag Investment Returns on almost every occasion. (For those of you who still insist that you can bottom pick and sell at the peak, I have an investment recommendation for you – here).
The ‘investor’ is often the weakest link in the investment process. As human beings we are prone to biases. We process information using heuristics. We make decisions based on our emotions. We are over confident, we over trade and we under diversify. These are but a few causes of the behavioural gap we are talking about. As an active human investor, there is a Performance Penalty we have to pay.
The Importance of Tracking Returns
The genesis for this article came about after a coffee session last week with a fellow investor. The short story was that he sold his house some years ago and ploughed the entire sum into the market via Joel Gleenbatt’s Magic Formula strategy. It worked well enough for him to retire way ahead of his peers.
Throughout the entire conversation, the subject of tracking investment returns kept popping up. He is fastidious in monitoring his returns and watches it like a hawk. Even after the session, he texted me to compare and discuss returns further – it meant that much to him.
While he displayed a high level of conviction in his strategy, he remains open to learning, tweaking and even switching if someone with better returns come along.
Here is someone who understands that Investment Returns is not equivalent to Investor Returns most of the time. The reason why he tracks is to optimise Investor Returns, so as to match if not better Investment Returns.
We have long advocated the importance of tracking our investment returns. The hallmark of a good investor lies in his or her ability to track returns. The pros track, amateurs never do.
And in the investing arena, amateurs with their easy money are nothing but sitting ducks for the pros.