Think about running a race. Surely, before you even start running, you would identify the race you want to run, the distance and the starting point? Or would you just start running from anywhere and hope that you'll land up somewhere in Knysna with someone handing you a cold beer?
This week, I am taking a break from discussing the technical analysis of investments, and want to look at investment goals, specifically at how you measure success.
There are three aspects to investment goals:
- The "what" is about how you determine whether or not you have achieved your objective.
- The "how" focuses on the type of vehicles you use and the risks you take - for example, by how much the portfolio fluctuates over time.
- The "by when" is your time horizon - in other words, how much time it takes to achieve the goal.
Let's look at the "what" of investment goals.
My mother-in-law has a weakness for clocks, be they wall-mounted, standing, gilt-edged, second-hand and half-broken, chiming or quiet. None of her clocks show the same time. The clock in the lounge is about 16 minutes too fast (but this may vary, as it was a charity shop special). The one in the dining room is on European winter time, and the one in the kitchen is correct.
Trying to figure out the correct time when I am at my mother-in-law's reminds me of how some people determine whether or not their investment strategy has been successful. There are three basic ways of measuring the level of return that you want to achieve - setting aside risk for the moment.
You can set a clear, absolute investment goal. For example, you want to supplement your monthly income by R3 000, or you need R2 million in 10 years' time to retire, or you need your investment to grow by 7.5 percent a year. These goals are as unequivocal as the clock in my mother-in-law's kitchen. At the end of your time horizon, you've either made it or you haven't.
Then there is the benchmark or index goal.
For example, you are sure that a portion of your portfolio needs to be in equities in order to meet your long-term financial requirements. You know that you can buy an index fund for a low fee, but you are prepared to pay a little more for active management in the hope that your manager gives you something extra. In the case of the equity portion of your portfolio, you measure success as the return you get over and above the market return.
This is a little like the clock in the dining room that just has to stay one hour ahead for part of the year. A benchmark goal is also quite simple and relatively easy to measure, but the outcome is largely dependent on the index you choose.
The third way of setting goals is to compare your investment with its peers. I call it the looking-over-the-shoulder goal.
You don't have an absolute goal in mind, such as 7.5 percent a year, nor do you factor in what the market has done. You just want to be ahead - you want to be in a fund that out-performs its peers. This is like running your day using the clock in the lounge. Most of the time you're going to be a little early, but you could also end up running late.
There are two problems with using a peer measure as an investment goal. Firstly, the measure may be totally irrelevant to your ultimate investment needs. Picking the best fund manager (for this year...? in three years' time...? over the past three years...?) in no way ensures that you will reach your goal of, for example, an additional R3 000 a month. This is because the asset manager's track record may change and the product, which was the top performer over the past year, may not be the right one for you in the long run.
The second problem is that the process by which most investors choose to switch between managers is heavily flawed, and the costs of switching eat into your returns. Furthermore, poor timing when changing funds or managers can set your investments back for years.
In my early days in the markets, a very wealthy client scribbled the following investment mandate on a piece of paper: "Don't speculate with my money." Yes, those were the days before the Financial Advisory and Intermediary Services Act and the Financial Intelligence Centre Act, but he had a point. If constantly changing funds, investments or managers in order to out-pace someone else is not speculation, then I don't know what is.
To return to my race analogy. A sensible approach would be to get some information about the location, duration and terrain. Then you would probably set yourself a goal, such as beating your personal best time, which is a number that you know. Then you may want to choose a runner whom you'd like to out-run.
All investment goals should start with some clarity about the absolute numbers involved. Only then can you set relative benchmarks, and only then can you work at finding a fund or manager that can beat that benchmark better than the others.