How do you know if your stock-picking is paying off?
Are you winning? If you're in profit, does that mean you're ahead of the game? Or is it sufficient to say that you're not losing as much as the market?
These are not trivial questions, because if we are going to spend time and effort on investment, especially if we're picking shares, then we need know if that effort is being rewarded. We need to measure our performance relative to a benchmark.
Sure, we also get some pleasure from investing -- everyone needs hobbies -- but it's a much more enjoyable pursuit if we're achieving our objectives, and the objective of this particular game is to make money. Or more specifically, it's to maximise our return for a given level of risk.
And that's where it all gets rather messy. Many years ago, during the technology boom, a friend of mine explained how his investment in a managed fund was doing very nicely. "My money was earning peanuts in the bank." Which was true, but his funds were now invested in high-risk dot com companies.
He was earning much less than the NASDAQ index (the US market for technology stocks). On top of that, because of the way the fund was packaged he was losing nearly 7% per annum in various fees and charges. Much as I hated to rain on his parade, I had to point out that, not only was he being ripped off, he was not comparing like with like.
Comparing apples to apples
But to what exactly should we compare our portfolios? If we're comparing apples to apples, can we compare cooking apples to eating apples, or red apples to green apples? My point is that unless we are buying the benchmark index -- FTSE All-Share, for example -- our portfolios will differ from the index and have a different risk profile.
Some argue that if we're comparing to, and aiming to beat, a particular index then we should only pick shares from within that index. I find that absurd. It's no more illogical to differentiate a portfolio from the index by buying outside it than by not buying all of it; the risks and returns from either strategy can be dramatically different from those of the benchmark index.
We could get mathematical about it, and that's fun in a nerdy sort of way (yes, I know, I should get out more), but I'm not convinced that it helps us. Modern portfolio theory uses historical volatility as a proxy for future risk, but that's an idea that many, myself included, don't find particularly useful.
What's your default strategy?
Personally, I think it's more meaningful to compare my portfolio to the default strategy of simply tracking the FTSE All-Share, even though many of my investments lie outside this index; in other words, to compare it to what I'd probably do if I had no time to devote to the subject. That, while acknowledging outcome bias, gives me some feel for whether or not I'm wasting my time.
But of course even that default tracking strategy is not entirely devoid of judgement. My friend could have argued that his default strategy was cash in the bank, and that therefore his comparison was valid. And I could almost as easily have picked an international tracker, for example, which would give me a different relative performance, and consequently a different feeling of satisfaction or dissatisfaction. You pays your money and you takes your choice.
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