As investors, we appreciate great performance numbers. The TSX index has turned in stellar returns during the past four years. Even more impressive are the returns that have been produced by Canadian energy stocks (see figure 1).

Figure 1:  iShares S&P/TSX C60 and iShares S&P/TSX Capped Energy

Source: www.bigcharts.com

But with that, how many investors actually saw those returns filter to their bottom line. More importantly, if investors did not earn those returns, how many are unhappy with their portfolio? Without really understanding why!

Such is the nature of portfolios. The objective is to stay invested for the long term. The difficulty is that investors behavior is geared to the short term. The solution, if there is one, begins with an understanding of what causes the behavior and then, establish parameters to deal with it.

Cause and Effect

When investors hear about the great performance of specific stocks, sectors or markets, they tend to use that as a frame of reference to measure the performance of their own portfolio. Usually a well balanced portfolio has not kept pace, and that usually leads to disappointment. 

The most likely cause of the disparity is that the make up of the portfolio is not the same as the make up of the point of reference. Which is to say, a portfolio usually holds a combination of income and equity assets. Is it reasonable to compare the results of an income / equity split with the performance of a sector or an all equity mandate? 

Next is the related issue of transparency. No question that we want efficient markets, and that means having the ability to access relevant information instantly, and to be able to act on that information quickly. The worst thing that could happen is a liquidity crunch like the one recently witnessed in short term commercial paper. 

The problem is that transparency also provides the investor with a graphic short term evaluation of their net worth, which all too often, causes angst. And it’s usually not because of a flawed portfolio. 

If the market is rising, investors frequently view their net equity statement – something that can be downloaded daily if one chose to – and then evaluate that number within the context of the most recent market update. So let’s assume the TSX is up 2%, and your portfolio is up 1%. Will you be happy? 

And within a transparent market, there is no way to massage that number. Your securities are worth what the market values them at and that value is transparent. That’s very different that what we see in say, the real estate market. 

Suppose a home on your street sold for “X” dollars. If that price seems low – i.e. less than your expectations - you simply estimate the value of your home at “X+1” or some other number reflects what you believe to be an appropriate value. 

You can justify that value by establishing a set of parameters that distinguishes your house from the one that just sold. Perhaps you have a five piece bathroom, or a finished basement, or a swimming pool. In the end, unless you are moving, it is nothing more than a mental feel good exercise.

I cite real estate, because it is an asset class that has created wealth for a lot of Canadians. In fact, ask any Canadian what they think of real estate, and they most likely will say it is a great investment. 

Ask those same Canadians what they think f the stock market, and most would likely say it is a “crap shoot.” Yet, when you look at the long term numbers, the compounded annual return of real estate is about 3% less than the compounded annual return on stocks. With less risk than you might expect. 

The point is, if we were able to hold our stock portfolio like we do our real estate assets, it would do wonders for our bottom line. Average investors don’t do that, because our perception is, stocks are risky! So why does that perception exist? And more specifically why, if we take away the fact we need a place to live, look at two asset classes so differently? 

The answer in my opinion is twofold; 1) the transparency that accompanies liquidity establishes a hard price for financial assets leaving no wiggle room for investors to fudge the value and 2) that transparency leads one to review their investments more frequently, which increases dramatically the chance of being disappointed with the results. Whether or not the results are good or bad. Behaviorists refer to the latter point as myopic loss aversion. 

To get the most from your portfolio – whether doing it yourself or working with an advisor – you need to manage those issues. 

One way to deal with the first issue is to establish a frame of reference… a benchmark. Think of this as your – or your advisor’s – job description. 

I am not here to tell you what kind of asset mix makes a reasonable portfolio. Only you can define that. What I am saying is that you must define your portfolio and then establish a benchmark to gauge how well it is doing. If you are invested 100% in Canadian equity, then the TSX composite index would be an appropriate benchmark. If you hold 100% Energy stocks, then the TSX Energy sub-index would be an appropriate benchmark. 

Of course, most of us have a combination of assets. We are not 100% invested in stocks, nor are we invested entirely in bonds or GICs. Which means that your benchmark should reflect that combination to allow for an apples to apples comparison. Rather than looking at the financial news of the day for your point of reference, look at how your portfolio did relative to your benchmark.

The second point is intertwined with the first, in the sense that having a reasonable frame of reference should reduce the review frequency. That’s important, because myopic loss aversion is a behavior trait with natural, often, negative consequences. 

It is in fact, the same psychology that causes many weight loss initiatives to fail. Think about it! When you decide to lose weight, you have a point of reference that says; I am going to lose 50 pounds. 

Now let’s say, after day one, you get on the scale and it shows you have lost 2 pounds. That’s good! But unconsciously, you will be comparing that number to your 50 pound point of reference. Disappointment ensues because the 2 pounds is such a small fraction of the point of reference.

Weight loss clinics go to great length to remove that temptation by getting you to avoid stepping on the scales until you come in to the clinic for your periodic review. At that point, you step on the scales with a counselor from the weight loss program overseeing the results. The counselors’ job is to frame your expectations by putting context around the results on the scale. Whether you lost one pound or five pounds, your counselor will frame the weight loss as meeting or exceeding the expected result. That support goes a long way to keeping you in the program, ultimately leading to a successful conclusion. 

In the investment business, that’s what a good advisor should be doing. How well you trust and / or accept the advisor’s advice, goes a long way to determining what value that advisor brings to the table, and what he or she should be paid for that advice. 

In the end, the objective is to frame expectations with a point of reference, which in this case, is an appropriate benchmark. If the benchmark provides comfort, then it should lead to less frequent reviews. And that will keep you more focused on the longer term, which allows your portfolio to work its magic. 

In this case, producing the expected long term rate of return.